Fed Still has a few Surprises

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Following its final meeting of 2012 on Dec. 12, the Federal Reserve’s Federal Open Market Committee (FOMC) announced that it would continue adding assets to its balance sheet in an effort to keep interest rates low and stimulate the economy.

 

The FOMC’s decision to maintain its easing program was widely anticipated by both economists and investors, but the committee still managed to deliver some surprises in its post-meeting statement. While the Fed had previously pledged to continue with easing indefinitely, it said it will keep its stimulus efforts in place until the unemployment rate falls to 6.5 percent or inflation rises to 2.5 percent.

 

By tying its monetary policy to future economic indicators, the FOMC has adopted the “Evans rule,” named after Chicago Federal Reserve President and leading monetary dove Charles Evans. The rule suggests keeping short-term rates near zero as long as unemployment and inflation remain within specific parameters.

 

Now, the Fed is planning to double its monetary action, including purchasing $40 billion of mortgage backed securities. In 2013, it will also begin buying $45 billion in longer-term Treasuries every month. Once its current Treasury-buying program, dubbed “Operation Twist,” concludes at year-end, the Fed intends to broaden the range of Treasury maturities it purchases from the current six- to 30-year band to a slightly wider 4- to 30-year band.

 

Credit Suisse Chief Economist Neal Soss expects the Fed to maintain its easing program, known as QE3, through next year.

 

“We anticipate QE3 will persist throughout 2013, potentially expanding the (Fed’s) balance sheet by more than $1 trillion by this time next year,” Soss writes in the bank’s latest U.S. Economics Digest.

 

Last week’s announcement wraps up an eventful year for the Fed, which has seen a lively debate between FOMC inflation hawks and doves over the need for continued easing. With the year winding down, the decision to base its latest action on the so-called Evans rule indicates the doves are currently in the ascendancy.

 

But, while linking Fed action to the unemployment and inflation rates is both surprising and novel, it is not without its critics. Soss notes that last week’s announcement “heralded yet another innovation in Federal Reserve monetary policy,” but he argues that the move could leave many wondering exactly when the Fed will end its easing program.

 

“By leaving itself so much leeway and adopting its own inflation projections as one of the thresholds for policy, the Federal Reserve risks creating more confusion than clarity,” Soss writes.

 

Still, from Operation Twist to the decision to launch a third easing program,  most people can agree that 2012 has been a watershed for the Fed. Now, with both the President and Congress promising to reduce deficits and curb spending, the Fed’s role in promoting growth may become even more important, and 2013 could end up being just as transformative as 2012.

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