The Fed decision was fairly close to what was anticipated in this earlier blog – all “twist” and no “shout”. However, on balance, the statement was slightly more dovish than I expected. Concerns about downside risks to economic activity were at least as great as in last month’s FOMC statement, with new downside risks from financial strains being specifically mentioned, and this has swayed the majority of the committee to introduce a slightly more aggressive operation “twist” than expected. Inflation concerns, while marginally greater than in the August FOMC statement, are clearly insufficient to impress the committee, which remains biased towards further easing even after today’s announcement.
To start with Operation “twist”, the quantum of long bond purchases, was at the high end of the $300-400m range, which was generally expected, and will therefore involve removing more bond duration from private hands than had been anticipated. The Fed has announced up front that the operation will take place between now and next June, rather than leaving its size to be determined on a monthly basis. This is a more decisive easing step than many expected.
Although there will be no expansion in the balance sheet, the impact of this operation on the term premium on long bonds (and therefore on long bond yields) will be roughly the same as it was under QE2 (Estimates of the effect are around 50 basis points at most, and much of this is probably already in the market.) This is because the central bank will remove the same amount of bond duration from market hands as occurred under QE2, over roughly the same time horizon. Therefore, this amounts to a fairly heavily disguised “QE3″. It will be interesting to see whether it has the same impact on financial markets. The method used in QE2 was easier to understand, so the “shock and awe” announcement effects may be less.
There was no new action today in the category of operation “shout”. The FOMC statement on holding short rates near zero for two years was the same as last time. However, the Fed has added a new phrase, warning of significant downside risks to the economy, stemming from financial strains and other unnamed sources. There has been some initial disappointment in equity markets, presumably because the Fed sounds worried about the economy but does not seem to have any drastic new weapons ready to deploy.
The majority of the FOMC are clearly not impressed by recent inflation data, which have indicated that the underlying rate of core inflation is still rising. They have taken the view that this has occurred because recent energy and food price rises are still working through the system. Once that has happened, the majority are convinced that core inflation will start to fall again, because excess capacity in the economy will dominate the picture. They are probably right about this.
The only slightly unexpected part of the statement was the decision to use the proceeds of mortgage security redemptions to purchase new mortgage securities, thus marginally helping the housing market.
Although there were three dissenters from the FOMC statement, the majority view remains biased towards further easing. This can be deduced from the following paragraph in the statement:
“The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools as appropriate.”
This means that, even after today’s operation “twist”, the Committee thinks that further easing action could well be needed. Hence, the split on the committee is increasing in intensity; three members do not even support today’s easing, while the majority are hinting that more could be coming soon.
As markets digest the statement, they will probably realise that its effects are very similar to those of QE2, but without the balance sheet effects that inflamed political opinion. QE2 increased the size of the monetary base. This new action does not do that. Instead, it leaves more short term government debt in market hands, which has very similar effects to increasing the monetary base, but does not technically count as an increase in the money supply.
Those who did not like QE2 will probably not like this either, on the grounds that its effects are similar, but disguised. Those who want more drastic action to stimulate the economy will say this is better than nothing, but not enough.
The split on the FOMC is also reflected in increasingly bitter political differences on recent Fed easing, with the Republican presidential candidates now attacking the Fed in unison. Of course, the Republicans are entitled to express their point of view on the efficacy of monetary easing, but the terms of recent attacks on the Fed are unusual.
Whatever one thinks about politics, the Fed will be very uncomfortable at being dragged into the political debate in this way. This could make it more difficult for the FOMC to simply do what it believes to be the right thing as it takes account of the incoming evidence. The whole point of having a semi-independent Fed is to allow them to make the best economic response to the developing situation. Politicising the Fed, from any side, will not help market confidence.
The next debate at the Fed will probably be whether to do more on operation “shout”. It will not be easy for the FOMC to reach agreement on the appropriate action to take in this area, but some further moves seem likely before very long.
