FOMC Preview

The Federal Reserve's two-day meeting begins today. Given the proximity of the election and the fact that an open-ended asset purchase plan was announced last month, there will be a great deal more talk than action at the FOMC meeting. 

There are two issues that market expects the Fed to discuss. The first may fall under communication, but is really more substantive. Currently the Fed uses a calendar date approach, now mid-2015 to guide expectations of the minimum amount of time the Fed will keep interest rates low. There has been some talk, led perhaps by the Fed's Evans, but clearly a topic at the Jackson Hole confab, that perhaps the Fed should provide numerical targets.

Evans, for example, has talked about expanding pursuing QE until the unemployment rate is below 7% or if inflation rises above 3%. There continues to be much talk about targeting nominal GDP. The challenge is agreeing on what indicators to target and at what levels. Kocherlakota, who previously called for a rate hike by the end of this year, now suggests numerical targets of 5.5% unemployment or 2.25% inflation.

The second issue addresses the amount of securities the Fed is purchasing. The question here is whether the Fed should roll the $45 bln a month in Treasuries it is buying under Operation Twist (and selling short-end holdings) and roll them into QE3+. This would mean buying $85 bln a month in MBS and Treasuries a month.

Operation Twist is to be completed by the end of the year. The Fed does not have to decide this now and so it won't. To some extent, it is likely data dependent. The FOMC statement itself is likely to recognize the better stream of economic data recently. However, in itself it probably does not meet the Fed's threshold of substantial and sustained improvement in the labor market.

Moreover, there is greater uncertainty among businesses, even if not consumers, where confidence appears to have strengthened, over the fiscal cliff and debt ceiling issues. Last month the FOMC updated its GDP forecast for next year to 2.5%-3.0% (from the June forecast of 2.2%-2.8%). Although the assumptions were not made explicit, it must assume the limited fiscal headwinds next year.

When and if the Fed cuts in 2013 GDP forecasts (the Bloomberg consensus is for 2% growth, which also seems to implicitly make assumptions about the thrust of fiscal policy), it likely announce a change in its asset purchase program. It could come as early as December, when its forecasts are updated.

Many observers are skeptical of the merits of the Fed's asset purchases and question its effectiveness. And even those a bit more sympathetic have suggested it is now yielding diminishing returns.

The linkage between increasing bank excess bank reserves, removing some risk-free assets from the market, boosting the demand for risk assets and job creation is difficult to envisage.

The most potent criticism is that monetary policy cannot address what ails the US. Some extend the argument backwards to the Great Depression and note that it was fiscal policy (WWII spending) that ultimately succeeded not monetary policy. Perhaps to square the circle, one can admit the charge that increasing the central bank's balance sheet is really an exercise in fiscal policy not monetary policy. 

Some observers have opined that if Romney wins, that Bernanke is out and QE3+ is over. While we recognize that in the heat of the campaigns, partisans say all sorts of things, the situation strikes us as more complicated. Bernanke's term runs through 2013. There are good reasons why the Fed chairman's term is not the same as the presidential term. It speaks to the independence of the Federal Reserve.

Even though Bernanke was first appointed by Bush, Romney has made is clear he would not reappoint Bernanke. At the same time, more controversially, we suggest that if Obama gets re-elected, Bernanke may also not be reappointed. Here we are sensitive to idea that after Greenspan's long tenure and the credit crisis, for which he fairly or unfairly has been blamed to some extent, there may be informal term limits.

The parallel we see is with the US presidency. Prior to FDR there was an informal term limit of two terms. FDR broke with tradition and afterward a constitutional amendment turned the tradition into the law of the land. Even if analysis is correct, the end of Bernanke's term does not necessarily mean the end of QE. Obama could nominate Yellen or Dudley which would signal continuity.