Fed
FAQ: Fanning the FOMC Flames
What Are the Fed’s Options at This Week’s FOMC Meeting?
This
week’s meeting of the Federal Open Market Committee (FOMC) is the fourth of
eight such meetings this year. Along with releasing a decision on monetary
policy at 12:30 PM ET on Wednesday, June 20, the Federal Reserve’s (Fed)
policymaking arm will also release its latest forecast of the economy, the
labor market, and inflation at 2:00 PM ET on June 20, followed shortly by a
press conference with Fed Chairman Ben Bernanke.
The
market now expects some action from the Fed at this meeting. If the Fed does
nothing — lets Operation Twist end as planned on June, 30, 2012 without replacing
it with something else — markets will likely be disappointed.
Extending
the commitment to keep the Fed funds rate near zero beyond the end of 2014 is
the minimum the Fed could do to keep markets placated. The Fed first announced
its commitment to keep rates near zero in August 2011, at the time, committing
to keep rates near zero until mid-2013. In January 2012, the Fed extended its
promise to keep rates at exceptionally low levels until late 2014. Still, the
markets would, at least initially, view a change in the Fed’s commitment to
keep rates on hold as a disappointment relative to current market expectations.
If
the Fed does nothing, but hints (either in the statement or via comments made
by Bernanke) that further action may come as soon as the August 1, 2012 FOMC
meeting, the markets would still likely be disappointed. The markets' focus
then would shift to Bernanke’s press conference and back to the Fed’s new
economic forecast, as participants try to gauge the timing of the next round of
stimulus.
Most
market participants now expect the Fed to renew Operation Twist. Twist involved
the Fed selling some of its shorter-dated Treasury holdings and purchasing
longer-dated Treasuries in the open market in order to keep long-term Treasury
yields lower for longer. When it was first announced in September 2011,
Operation Twist promised to purchase $400 billion in Treasuries by the end of
June 2012. If the Fed decides to extend the program, the size and timing will
be important. Will the Fed announce the size and the timing, or will it decline
to pre-commit to a full dollar amount or a specified timeline? Markets like
clarity, so the more specifics the Fed can provide around extending Operation
Twist, the better for the markets.
An
announcement that extends Operation Twist and hints that the Fed is prepared to
take additional action quickly would likely be viewed more positively by
markets than just extending Operation Twist beyond the end of June 2012. The
more specific the Fed is in any kind of conditional promise to “do more”
(extend Operation Twist, increase the size of its balance sheet, or some other
kind of stimulus), the better it would be received by financial market
participants. Specifics might include trigger points around inflation, economic
growth, the labor market, and possibly even on the situation in Europe. In our
view, however, there is a low probability that the Fed would get this specific.
Although
a few market participants expect the Fed to announce another expansion of its
balance sheet, which would represent the third round of quantitative easing
(QE3) by the Fed since the fall of 2008, this type of announcement would likely
be viewed highly favorably by markets. The Fed could choose to purchase more
Treasuries, mortgage backed securities (MBS), or both. As with extending Twist,
the more specifics (on size and timing of the planned purchases), the more the
markets will embrace the operation. The goal of QE3 would be to keep rates most
used to set loans for consumers, homebuyers, and businesses lower for longer.
In this scenario, the Fed could choose to make the purchases outright (as they
did in QE1 and QE2) or sterilize the purchases. This means that the Fed would
immediately borrow back some of the cash it injects into the financial system
as it purchases the securities in the open market. For our analysis of what
sterilized QE3 might look like, and why the Fed might choose this path, please
see the Weekly Economic Commentary from March 13, 2012, “To QE or not to QE?”
Why Might the Fed Opt To Do Nothing This Week?
In
our view, one of the key reasons the Fed might not want to pursue this course
of action (i.e., another round of quantitative easing) as early as this week is
politics. A third foray into balance sheet expansion so close to the elections
would likely subject the Fed to intense political scrutiny from Congress (and
internally as well) and may imperil the Fed’s independence in the years ahead.
However, if conditions became so dire that Chairman Bernanke felt it necessary to
act to avoid deflation, he would likely have the votes to do so. In this case, Bernanke
and the center of gravity at the Fed would probably like to keep some “dry powder”
on hand in case conditions in the United States (either economically or
fiscally) or abroad deteriorated.
What Else Could the Fed Do This Week?
At
various times over the past several years during the Great Recession and its
aftermath, the Fed has discussed several alternative measures of influencing
the economy via monetary policy. These include:
·
Gross Domestic
Product (GDP) targeting. Where the Fed would target a level of economic
growth and continue to pursue monetary policies until the GDP target growth
rate is achieved.
·
Inflation
targeting.
Similar to GDP targeting, the Fed would target a specific level of inflation
(currently, the Fed’s unofficial target is around 2.0%) and conduct monetary
policy until the inflation rate reaches or exceeds the target rate.
·
Target duration
of Fed Treasury and MBS holdings. This is similar to Operation Twist, as
the Fed would announce a specific maturity or duration target of its holdings
of Treasuries or MBS and conduct purchases and sales of these securities until
that maturity or duration target was achieved.
In
our view, it is unlikely that the Fed will pursue alternative measures at this
week’s FOMC meeting, but they remain options should the Fed run out of other
ways to impact the economy via monetary policy.
What Can the Fed Do About Europe?
In
recent public appearances, various Fed officials have cited the financial and
fiscal turmoil in Europe as possible triggers for more monetary policy easing
in the United States. Indeed, slowing U.S. economic growth, slumping consumer
and business confidence, and downward pressure on domestic inflation from
Europe are likely nudging Fed policymakers to act on domestic policy this week.
More
globally, the Fed will likely join in any efforts by global central banks to
provide liquidity, if warranted, to the global financial system in the weeks
and months ahead to help ensure that global financial institutions (banks,
insurance companies, and other central banks, central and local governments)
can continue to provide consumers, and small and large businesses alike, with
credit. As recently as November 2011, the Fed was part of a coordinated effort
by global central banks to expand interbank lending in dollars. Similar actions
are more likely than not in the coming weeks and months, and can be achieved
without the Fed expanding its balance sheet or changing domestic monetary
policy in any way.
Does the Fed Change Rates in an Election Year?
For
the record, the Fed has either raised or lowered (and in some cases both in the
same year!) its short-term policy rate in every single presidential election
year over the past 45 years. In general, the Fed wants to avoid mingling in
politics during an election year, and it may prefer to hold off on adjusting
policy in the months just prior to the elections in November. But when push
came to shove, the Fed acted to change policy as conditions warranted and will
likely do so again over the second half of this year if conditions warrant. Fed policymakers would likely prefer to not
begin a new round of quantitative easing in the weeks and months leading up to
the November 6 elections, leaving the Fed only a narrow window between the
scheduled end of “Operation Twist” on June 30, 2012 and the onset of the fall
presidential campaigns, which traditionally swing into high gear after Labor
Day.
Thus,
although there is likely to be political blowback if the Fed decides to act
this week, history is on the side of Fed action in this case.
Why Would the Fed Consider Acting This Week?
As
we have written in prior Weekly Economic Commentaries, the Fed has a dual
mandate to promote low and stable prices and to foster conditions that lead to
full employment. Recent data points on employment, the overall economy, and
inflation suggest that:
·
The
labor market is softening again, with the unemployment rate at 8.2% in June
2012, and is in danger of rising further over the remainder of this year, and
may not fall to the Fed’s forecast of 7.9% by the fourth quarter of 2012.
·
The
overall economy remains near stall speed and below the Fed’s forecast (2.75%
for real GDP growth in 2012 and 2.9% in 2013). The economy grew at just 1.9% in
the first quarter of 2012, and thus far in the second quarter of 2012 is on
track to post growth closer to 1.5% than 2.0%. Our forecast remains that the
economy will grow at 2.0% in 2012.
·
While
deflation, a prolonged period of falling prices and wages, is not likely, and
both headline and core (excluding food and energy) inflation remain above the
FOMC’s forecast range for 2012, headline inflation has decelerated sharply this
year and core inflation has stabilized. With plenty of slack in the labor
market, wage gains are nearly nonexistent. Since labor costs account for
roughly two-thirds of business’ costs, there is little ability to pass through
price increases. In addition, inflation expectations (of consumers, businesses,
and professional forecasters), a key input to the Fed’s process on monetary
policy, have barely budged in recent years and suggest that inflation
expectations remain well contained.
·
In
addition, the potential for much more restrictive fiscal policy next year as
tax hikes and spending cuts go into effect may prompt the Fed to provide more
stimulus. Indeed, financial conditions have already worsened (including
measures like interbank lending rates, yield curves, credit spreads,
price-to-earnings ratios, and the value of the dollar). Although conditions
have not deteriorated as much as they did prior to the start of QE2 in the fall
of 2010 or summer 2011 prior to the announcement of Operation Twist, financial
conditions have deteriorated rapidly since the start of April 2012.
Is There Evidence the Fed Is Failing to Achieve its Dual
Mandate?
In
recent public appearances, Fed officials of all stripes (hawks and doves) have noted
that the Fed is taking into account the lingering financial and fiscal crisis
in Europe, as well as the looming fiscal cliff here in the United States. While
these issues will likely be discussed at this week’s FOMC meeting, the
participants will want to rely primarily on how the economy is tracking towards
its dual mandate in making and communicating whatever decision it makes this
week.
In
the Fedlines section below, we cite recent speeches from two Fed officials who
point out that the Fed appears to be failing in one or both of its mandates.
FEDLINES
Yellen
and Dudley Make the Case for More Policy Action From the Fed
|
The section below contains excerpts
from a speech given by Fed Vice Chair Janet Yellen on June 6, 2012, in Boston
entitled: Perspectives on Monetary Policy.
While Yellen is a well-known monetary
policy “dove,” her views are thought to be closely aligned with Fed Chairman
Bernanke’s views.
“If the Committee were to judge that
the recovery is unlikely to proceed at a satisfactory pace (for example, that
the forecast entails little or no improvement in the labor market over the
next few years), or that the downside risks to the outlook had become
sufficiently great, or that inflation appeared to be in danger of declining
notably below its 2 percent objective, I am convinced that scope remains for
the FOMC to provide further policy accommodation either through its forward
guidance or through additional balance-sheet actions. In taking these
decisions, however, we would need to balance two considerations."
"In particular, as I have noted,
there are a number of significant downside risks to the economic outlook, and
hence it may well be appropriate to insure against adverse shocks that could
push the economy into territory where a self-reinforcing downward spiral of
economic weakness would be difficult to arrest.”
|
|
The section below is text from a
speech given by President of the Federal Reserve Bank of New York, William
Dudley, on May 24, 2012, in New York City.
Dudley is also a well know monetary
policy “dove.” We have long viewed Dudley, along with Yellen and Bernanke, as
the “center of gravity” of the Fed. His recent remarks can also provide some
insight into what the Fed may do next.
“As long as the U.S. economy continues
to grow sufficiently fast to cut into the nation’s unused economic resources
at a meaningful pace, I think the benefits from further action are unlikely
to exceed the costs. But if the economy were to slow so that we were no
longer making material progress toward full employment, the downside risks to
growth were to increase sharply, or if deflation risks were to climb
materially, then the benefits of further accommodation would increase in my
estimation and this could tilt the balance toward additional easing.”
|
Hawks: Fed officials
who favor the low inflation side of the Fed’s dual mandate of low inflation and
full employment.
Doves: Those favoring
the full employment side.
Prepared
by:
John
Canally, CFA
Economist
LPL Financial
__________________________________________________________________
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Quantitative Easing
is a government monetary policy occasionally used to increase the money supply
by buying government securities or other securities from the market.
Quantitative easing increases the money supply by flooding financial institutions
with capital in an effort to promote increased lending and liquidity.
The Federal Open
Market Committee action known as Operation Twist began in 1961. The intent was
to flatten the yield curve in order to promote capital inflows and strengthen
the dollar. The Fed utilized open market operations to shorten the maturity of
public debt in the open market. The action has subsequently been reexamined in
isolation and found to have been more effective than originally thought. As a
result of this reappraisal, similar action has been suggested as an alternative
to quantitative easing by central banks.
The Federal Open
Market Committee (FOMC), a committee within the Federal Reserve System, is
charged under the United States law with overseeing the nation’s open market
operations (i.e., the Fed’s buying and selling of United States Treasure
securities).
Treasuries: A
marketable, fixed-interest U.S. government debt security. Treasury bonds make
interest payments semi-annually and the income that holders receive is only
taxed at the federal level.
This research
material has been prepared by LPL Financial.
To the extent you are
receiving investment advice from a separately registered independent investment
advisor, please note that LPL Financial is not an affiliate of and makes no
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