As expected, the Federal Open Market Committee (FOMC) decided to extend its interest rate pledge into 2015 (and strengthened it) and launched a new and ‘open ended’ asset purchase program targeted at agency mortgage-backed securities (MBS), unsterilized (QE3 proper).
The Committee currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015. The pledge was not only extended, but also strengthened by the sentence that “the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens”.
The Fed will purchase agency MBS at a pace of $40 billion per month and will continue its purchases of agency MBS “if the outlook for the labour market does not improve substantially”. So it’s an open ended program, with a somewhat vague stopping criterion. The FOMC gave no explicit target for the unemployment rate below which it would terminate the purchase program. Unlike Operation Twist, the purchases of agency MBS will not be sterilized.
Operation Twist, the program to purchase longer-term US treasuries and sell an equal amount of short-term treasuries, also will continue through the end of the year, as announced in September.
Together, these two asset purchase programs will increase the Fed’s holding of longer-term securities by about $85 billion per month through the end of the year.
The decision was not unanimous, as Lacker voted against the action because he opposed additional asset purchases and preferred to omit the description of the time period over which exceptionally low levels for the federal funds rate are likely to be warranted.
The rationale for FOMC actions is that the Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labour market conditions.
Interestingly, if we look at the economic projections of FOMC participants, the GDP forecasts for 2012 were revised downward compared to the June projections, but the outlook for 2013-2014 was revised upward. Unemployment rate forecasts remained essentially unchanged for 2012 and 2013, but were revised downward for 2014. Inflation forecasts for 2012-2014 were revised upward. Perhaps FOMC participants already incorporated the impact of today’s decision in the projections they submitted.
What’s next?
An intriguing fact of the FOMC statement was that the stopping criterion does not only apply to agency MBS. Literally, the statement was that “If the outlook for the labour market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability”.
First, let’s think about “additional asset purchases”. The Committee may be telling us that when Operation Twist has ended, and the labour market has not improved substantially, we may see additional purchases of longer-term treasuries. Probably unsterilized, because the Fed’s stock of short-term treasuries will be close to zero by then. In fact, that would be a continuation into 2013 of the simultaneous purchases of agency MBS and longer-term treasuries that we are going to see for the remainder of 2012, but without any sterilization. However, the FOMC could also decide to step up the pace of purchases of agency MBS if it remains unsatisfied with the improvement in the labour market.
Now, let’s look at “other policy tools”. One tool is the interest rate pledge. If the labour market does not improve, the FOMC may decide to extend the pledge beyond mid-2015. Another policy tool is the interest rate on excess reserves that now stands at 0.25%.
The ECB has recently shown that a reduction below 0.25% does not necessarily destabilize the money markets. Finally, the Fed could also introduce an American version of the Bank of England’s Funding for Lending Scheme (FLS).
Keep in mind that this additional monetary policy stimulus was caused by the weak momentum of the economic recovery. But at the start of 2013, the economy is facing the fiscal cliff. This confluence of the expiration of the Bush tax cuts, the end of the payroll tax break and the start of the automatic spending cuts will deal another blow to the economic recovery.
Post-election negotiations between Democrats and Republicans are expected to scale down the size of the fiscal cliff, but there will remain a substantial negative fiscal impulse. This may be the trigger for the FOMC to provide additional monetary stimulus beyond what was decided on Thursday.
Source: Rabobank International
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