Thursday, September 13, 2012


FOMC Report
September 12-13, 2012


‘The Fed could succumb to recent pressure, both internal and external, to recognize a need to give the market some guidance toward what is an acceptable level of inflation and what is an acceptable gap between potential and actual economic output with respect to maintenance of an accommodative monetary policy.’

I wrote the above for consideration 9 years ago in a report for the September 16, 2003 FOMC meeting. It appears the Fed will still be intently discussing this topic at this September 12-13, 2012 meeting as they try to determine if an extension of guidance, an increase in LSAP, the two combined or some other measures might be appropriate for propping up suboptimal growth.

Against the backdrop of disappointing reports from the manufacturing sector and failing consumer confidence, the generally modest tone of economic growth expressed in the most recent Beige Book stands in contrast with the stated requisite improvement indicated necessary in the August FOMC minutes for the Fed to refrain from initiating additional accommodation. While Mr. Bernanke will not have complete agreement that further measures need be taken, it is believed he has the will and the votes to pass measures. The glide path for economic growth is dangerously low and there is little room for negative shock to be absorbed without the economy falling into a recession.

Some might argue that the recent expansion of the Maturity Extension Program (MEP) leaves little room for further accommodation at this stage. Others suggest that the MEP might be shelved and a more aggressive LSAP (QE3) initiated. While recognizing the limited benefit from such efforts, I believe the Fed will announce another program of asset purchases, quite possibly involving mortgage securities.

I read a wonderful report by Michael Woodford that was released at this year’s Jackson Hole Symposium titled‘Methods of Policy Accommodation at the Interest-Rate Lower Bound *’ It is rather instructive in the way it presents the findings on the nature, intent and success of ‘forward guidance’ and ‘balance-sheet policies’. He also presents a strong argument for targeted nominal GDP.

Mr. Bernanke as recently as August 31 referred to LSAP’s conducted thus far as finding benefit from the
‘Portfolio Balance Channel’, where non-perfect substitutability of financial assets can promote portfolio adjustments supportive of Fed goals. However, it is argued in the Woodford paper, citing additional research, that much of the reduction in treasury yields seen immediately following LSAP initiation might be attributed to the parallel announcement of policy guidance intention; which in an effort to keep your reading time manageable today, brings me to the point I would like to make.

If the assertions are correct or well enough believed that much of the reduction in long-term yields are attributable to forward guidance then we should not expect to see a new LSAP program announced alone with no accompanying extension of forward guidance. Some might rightly argue that the Fed should come alone with an extension of forward guidance, possibly a more forceful message or a less conditional one. However, I understand Mr. Bernanke as a strong believer in the ‘Portfolio Balance Channel’ and he will want to increase these efforts. If he is a man willing to take out insurance, then we should expect he would rather have the ‘cover’ of extended guidance announced along with LSAP.

It is my belief therefore that there are very strong odds we shall receive an announcement for additional LSAP (QE3) at this September FOMC meeting. There is good argument that these efforts will be postponed till December (after the election). However, if announced LSAP measures are forthcoming, we should further expect the Fed to announce an extension of the policy guidance. To announce QE3 without extending guidance presents the risk that QE3 alone will be found insufficient to lower long-term yields.

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