Most
Asked Fed Question May Go Unanswered
This
week marks the first anniversary of the latest round of increased transparency
by the Federal Reserve (Fed) as Fed Chairman Ben Bernanke will kick off a
second year of post-Federal Open Market Committee (FOMC) meeting press
conferences on Wednesday, April 25. Bernanke’s first post- FOMC press
conference was held on April 27, 2011. Bernanke also held press conferences
after the FOMC meetings that ended on June 22, 2011, November 2, 2011, and
January 25, 2012. While the media is likely to put most of the focus on
Bernanke’s press conference and on the statement released after the FOMC
meeting, market participants will likely be primarily focused on the FOMC’s
latest forecast of the economy and the path of interest rates and how those
forecasts compare to the FOMC’s judgment of “normal” or trend growth in the
economy. By the end of the week, the market would like to be able to more
clearly assess the odds of more monetary stimulus from the FOMC when the
current round of stimulus — Operation Twist — ends at the end of June 2012. In
our view, despite all the information flowing from the Fed this week, that
question might go largely unanswered, leaving the timing of or the decision to
implement another round of easing up to the flow of economic data and events
over the next few months.
Fed Issues
The
issues at hand for Chairman Bernanke at the conclusion of the meeting include
deciding on the fate of Operation Twist, or as it is officially called the
Maturity Extension Program, which ends on June 30, 2012. Operation Twist was
hinted at by Bernanke in August 2011 and was implemented following the
September 21, 2011 FOMC meeting. Its goal was to keep long-term rates, used by
financial institutions to set rates for consumer and business borrowers, lower
than they would have otherwise been by selling some of the Fed’s existing
holdings of shorter dated Treasury holdings and buying longer dated Treasuries in
the open market. While some market participants continue to debate the
effectiveness of Operation Twist, the market’s real concern is likely to be
what happens next.
What
the FOMC decides to do once Operation Twist ends, if anything, will largely be
determined by how economic (Gross Domestic Product [GDP] growth and the
unemployment rate) data along with inflation excluding food and energy prices
(core inflation) behave in absolute terms, and also relative to the FOMC’s
projections for these metrics. As part of the increased transparency, the FOMC
began publishing its forecast four times a year following each of the two-day
FOMC meetings, in April 2011. Prior to that, the FOMC published its projections
for key economic variables, but with a lag, including the forecasts in the
minutes of the FOMC meeting, which are released three weeks after the
conclusion of the meetings.
Fed Forecasts
The
forecasts made at the January 24 – 25, 2012 FOMC meeting saw a slightly lower
path for GDP growth in 2012 and 2013 (versus the forecast made in November
2011), but also a slightly lower (better) unemployment rate forecast than was
made in November 2011. The FOMC’s projections for inflation in 2012 and 2013
were little changed between the November 2011 forecast and the January 2012
forecast.
The
forecasts released by the FOMC this week will likely show slightly stronger GDP
growth for 2012 than the forecast made at the January 2012 FOMC meeting, and a
slightly lower (better) unemployment rate forecast. The inflation forecast is
likely to be little changed.
These
forecasts are best viewed in comparison to the FOMC’s projections of the “long
run” forecast for each of the variables. The forecast for real GDP growth over
the long run (a good proxy for where the FOMC thinks the “normal rate” of
economic growth is) made in January 2012 pegged GDP growth at around 2.5%, the
“normal” unemployment rate at 5.6%, and overall inflation near 2.0%. Over the
past few years, the FOMC’s view of the long-term potential growth rate of the
economy has moved down a bit, while its forecast of the “normal” unemployment
rate has crept up a bit. Its forecast of what the “normal” rate of inflation is
over the long term hasn’t budged much.
Fed Policy Firming
Also
of interest to market participants will be any shift in the FOMC’s view on when
the first “policy firming” (or what we used to call a rate hike) by the FOMC is
likely to occur. Again in the spirit of increased transparency — which has been
a hallmark of the Bernanke Fed, especially since the onset of the worst of the
Great Recession and financial crisis in early 2009 — the FOMC began publishing
the forecasts of its own policy actions at the conclusion of the January 2012
FOMC meeting. At that meeting, well more than half (11 of 17) FOMC members
expected the FOMC’s first policy tightening in 2014 or later. Five of the 17
members of the FOMC expected the FOMC’s first “policy firming” to occur in
2015, but notably, two of the FOMC’s more “dovish” (those who favor the
employment portion of the Fed’s dual mandate to promote full employment and low
and stable inflation) members didn’t see any policy firming until 2016! At the
other end of the spectrum, three of the more “hawkish” (members who favor the
low and stable inflation side of the Fed’s dual mandate) saw the FOMC first
firming policy this year. This time around, we could see a few of the four
‘15ers join the five ‘14ers, given the somewhat better tone to the economic
data (until the last few weeks) since the January 2012 FOMC meeting.
Putting It All Together
In
short, this week’s FOMC meeting, the accompanying policy statement, the
Bernanke press conference, the FOMC statement, and the accompanying economic
and policy projections are likely to provide plenty of fodder for financial
markets in an already busy week for corporate earnings and economic data.
However, the key question the market wants answered this week: Will the Fed
embark on another round of quantitative easing (QE3) once Operation Twist ends,
may go unanswered.
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IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are
not intended to provide specific advice or recommendations for any individual.
To determine which investment(s) may be appropriate for you, consult your
financial advisor prior to investing. All performance reference is historical
and is no guarantee of future results. All indices are unmanaged and cannot be
invested into directly.
The economic
forecasts set forth in the presentation may not develop as predicted and there
can be no guarantee that strategies promoted will be successful.
Stock investing
involves risk including loss of principal.
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).
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.
This research material
has been prepared by LPL Financial.
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