There are two important issues to be discussed at next week's FOMC meeting. One is the issue of specific thresholds as future policy guides. The second is the replacement for Operation Twist. Clearly, support is building for specific thresholds, and I believe policymakers will work out the details within the next meeting or two. Also, I think the general sense is that the Fed will continue to purchase long-term Treasuries after Operation Twist is complete. But will they continue to purchase the full $45 billion a month? That seems like it should be an open question, but it looks like momentum is building in that direction.
St. Louis Federal Reserve President James Bullard offered his thoughts on both these topics yesterday. On the first point, he offers support for replacing the forward guidance with a set of thresholds. I don't find this to be surprising. Bullard has never been a huge fan of the time commitment implied in the current statement. Not only does it send a pessimistic signal about the economy, in theory it should respond more flexibly to evolving economic events. But in practice, the Fed is only willing to alter the date in the event of a substantial shift in the economic outlook.
Bullard cites the 6.5/2.5 unemployment/inflation thresholds recently described by Chicago Federal Reserve President Charles Evans. I am not sure that Bullard specifically endorses these figures, but he may sense the political wind is blowing in that direction. He nicely describes six challenges to a threshold regime:
- The Fed needs to make clear that in the long-run the Fed cannot target unemployment.
- He believes the threshold should be on actual outcomes, not forecasts.
- The Fed needs to communicate that policy is about more than just two variables. For example, he suggests the possibility of raising interest rates to limit asset price bubbles.
- Unemployment is not the only measure of the labor market. The Fed takes a broader view of labor markets into consideration.
- Unemployment can remain high, such as in Europe (I think this is really just a restatement of point one).
- Beware that thresholds will be viewed as triggers, which they are not.
I think these are valid concerns the Fed needs to address as the communication strategy evolves. Bullard then shifts gears to Operation Twist. Currently, large scale asset purchases come in two flavors. One is $40 billion a month in outright mortgage purchases (QE3), the other a monthly swap of $45 billion in short-term Treasuries for an equal amount of long-term Treasuries (Operation Twist). The former is open-ended, the latter concludes this month. Should it be fully converted to an outright asset purchase program? San Francisco Federal Reserve President John Williams gave his opinion last month:
Meeting with reporters following a speech at the University of San Francisco, MNI asked Williams whether he thinks the FOMC should replace the Operation Twist Treasury purchases dollar for dollar upon their expiration Dec. 31. He answered strongly in the affirmative.
"My view is based on the expectation that we won't see substantial improvement in the labor market" for awhile, Williams said, adding that therefore "my view is that we should continue with purchases of long-term Treasuries after December into next year."
Williams said he favors "just purely buying long-term Treasuries at the rate we're buying."
Asked to clarify, Williams said he favors buying MBS and Treasuries "at the same rate we're doing now" -- $85 billion per month.
Boston Federal Reserve President Eric Rosengren agreed yesterday. Operation Twist changes the composition of the balance sheet, not its size. If the Fed converts to an outright asset purchase program, they will more than double the pace of net purchases. In my opinion, this appears to be a substantial easing of policy. Bullard feels similarly:
...on balance I think it is reasonable to think that an outright purchase program has more impact on inflation and inflation expectations than a twist program....
...Replacing the expiring twist program one-for-one with outright purchases of longer-dated Treasuries is likely more dovish than current policy.
I think that is correct; the conversion of Operation Twist should be considered a more aggressive policy. Yet inflation expectations (with the usual caveats about TIPS based expectations) continue to wane:
Perhaps financial market participants do not expect the Fed to commit to the full $85 billion in purchases. But this does not seem to be the case. There has been more than enough Fedspeak to suggest that additional easing is coming. Which leads me again to wonder if monetary policy is now at full throttle? $40, $50, or $85 billion a month. Does it make a difference? Or is the expectation of additional easing simply offsetting expectations of tighter fiscal policy?
Bottom Line: The Fed is gearing up to convert Operation Twist to an outright purchase program. A complete conversion should be considered a more aggressive policy stance. If the Fed wants to hold policy constant, then we would expect a less than one-for-one conversion. There are reasons to expect the Fed would go the full monty. Notably, the fiscal cliff drama already appears to be affecting the economy, even though it is more risk than reality. But why are inflation expectations sliding? And what does that imply about the effectiveness of additional easing at this juncture? Important but as of yet unanswered questions.