The Fed did what we expected…but a few months earlier than we had anticipated

Genevieve Signoret & Patrick Signoret

(Publicaremos la versión en español de esta entrada el viernes.)

Yesterday’s FOMC monetary policy statement contained two important changes.

The first was a switch from Operation Twist to outright purchases after the Operation Twist program ends on 31 December 2012. Under Operation Twist, the Fed has been buying longer term Treasury bonds at a pace of $45 bn per month but offsetting those purchases by selling equal amounts in shorter term Treasuries. Starting in January, the Fed will continue buying the same amount of longer term Treasuries as before. Only now, it’ll buy them “outright”—the Fed won’t offset these purchases by selling equal amounts of other assets but instead will “print” money (electronically)—thus expanding its balance sheet.

Under QE3, announced last September, the Fed was already expanding its balance sheet at a pace of $40 bn per month by buying mortgage backed securities. Now its balance sheet will expand at more twice that pace ($85 bn/month). (See a graph of the balance sheet below.)

Both the market and we expected this announcement. What we didn’t expect—yet—was the Fed’s second big decision: to enhance its communication strategy by setting numerical guidelines instead of fixed dates for how long the central bank would keep its policy “highly accommodative” (the federal funds rate near zero). Here’s what we published in our quarterly forecast report last September:

Current forward guidance says “To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.” We think that the Committee will get specific on what they mean by a strengthened recovery. For example, a specific target for the unemployment rate.

But we expected that to happen sometime in the first half of next year. Here’s an excerpt from our weekly global market and macro asset allocation report, La Carpeta Negra, last October 8:

We see the Federal Reserve changing its language in the next six months: rather than say it will keep money loose till a certain date, it may state that it will do so till it observes particular economic outcomes, such as a drop in the unemployment rate to some specified level.

The Fed did just that, but sooner than we thought. It stated that, as long as inflation doesn’t rise above 2.5% and longer-term inflation expectations remain well anchored, the FOMC will keep its monetary policy rate exceptionally low until unemployment falls below 6.5%.

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. The Committee views these thresholds as consistent with its earlier date-based guidance.

That isn’t NGDP targeting, but it is a step towards it. It’s the same strategy proposed by Chicago Fed President Charles Evans for the first time in September 2011 (except that he proposed 7% and 3% thresholds).

Notice two things:

1. These are not fixed rules; the FOMC will be looking at many factors. In the press conference, Bernanke stressed that the thresholds were “guidelines”. For example, the FOMC will watch longer-term inflation expectations to make sure they remain well anchored. That hasn’t been a problem so far (click to see the full-sized graphs):

2. The FOMC consider their new numerical guidelines as consistent with their previous consensus that the federal funds rate would remain close to zero until 2015. This is because they don’t expect the unemployment rate to fall below 6.5% or inflation to rise above even 2% through 2015, as the FOMC’s new economic projections show:

More reading (and viewing):

Watch Bernanke’s press conference (or read the transcript):

Tim Duy was surprised and pleased. Here’s his take on the FOMC projections and his thoughts on the press conference.

For Spanish speakers, we like El País’ article on the Fed decision.

Finally, the Fed’s balance sheet today: