FOMC Policy Announcement

FOMC Doubles Down on QE3, Funds Rate Tied to Unemployment Rate 

  • Operation Twist will end this month as expected.
  • QE3 will be expanded to include $45 billion per month of longer-term Treasury bond purchases.
  • Principle from maturing securities will continue to be reinvested, bolstering the QE effect.
  • There is no time limit for QE3. The duration of the program is dependent on economic conditions.
  • The near-zero fed funds rate has now been tied to an unemployment rate target of 6.5 percent.
  • The Fed has increased its tolerance for inflation, to 2.5 percent, up from a previous target of 2.0 percent.

Today at the regularly scheduled meeting of the Federal Reserve’s Federal Open Market Committee, the FOMC took several significant steps. As expected, Operation Twist will end this year. Operation Twist is the program of selling short-term Treasury bonds and purchasing an equal amount of longer-term Treasury bonds with the intent of flattening the yield curve.  That program was money-neutral, having no net effect on the money supply and therefore no direct push to inflation. The Fed will now add T-bonds to its program of outright bond purchases known as QE3. QE3 was launched in October as a program of purchases of $40 billion per month of agency mortgage backed securities. The goal of QE3 was to put downward pressure on mortgage interest rates and encourage a marginal shift in the market toward riskier asset purchases. In addition to the agency MBS purchases, the Fed will now add $45 billion of longer-term Treasury bond purchases. This is not money neutral. Further, QE3 has no set end date. This may potentially unhinge inflation expectations and the Fed does allow for at least a little of that. QE3 will remain in place until the Fed thinks that economic conditions have improved enough. There is no specific unemployment rate target for QE3. However, the Fed has announced an unemployment rate target for the fed funds rate. Previously, the Fed had pledged to keep the fed funds rate near zero through mid-2015. Now that deadline has been replaced by an economic target, namely, an unemployment rate of 6.5 percent. This action ties monetary policy more directly to the outcome of the fiscal policy debate about the Fiscal Cliff. In the absence of an agreement to roll back the Fiscal Cliff, the unemployment rate can be expected to stall or increase through 2013, thus pushing back the timeline for the eventual increase in the fed funds rate. The Fed has announced a tolerance for more inflation. In addition to the unemployment rate target for the fed funds rate, an inflation condition must also be met. One to two year inflation projections must not exceed 2.5 percent in order for the fed funds rate to remain near zero.  This lifts the Fed’s previous two percent ceiling for inflation.

Today’s monetary policy announcement marks a significant response by the Fed to its fear that economic growth might not be strong enough to generate sustained improvement in labor market conditions. It also suggests that highly accommodative monetary policy may remain in place longer than previously thought. Codifying an unemployment rate target of 6.5 percent for the near-zero fed funds rate is new territory for the FOMC. On the one hand it may increase the transparency of monetary policy. On the other hand it ties monetary policy more directly to the Fiscal Cliff debate now in full gale in Congress. The next move by the Fed will likely be no move for several months. It will wait to see the impact of today’s announcement and its new policies, and it will wait to see what happens in Congress.

Market Reaction:U.S. equity markets rallied with the FOMC announcement. Treasury yields initially rose at long end of the yield curve as equity prices jumped. Crude oil is up to $86.85/barrel. The dollar is up against the yen and down versus the euro.

Click here for a PDF version of the Comerica Economic Alert: FOMC 121212.

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