FT Alphaville " Preview for 13 September 2012 FOMC statement and presser In a great post over at Money Supply, Robin Harding explains the main source of suspense for today's FOMC statement and presser (our emphasis): For me, the question of what the Fed will do is far less interesting - and far less in doubt - than how the Fed will do it. This will not be a pro forma repeat of previous actions. As Mr Bernanke's speech shows, the Fed is trying to address grave concerns about the labour market. The crucial issue is whether and how they tie any action to the state of the economy. There is a lot of desire on the committee to use open-ended asset purchases. Hawks like open-ended purchases because they can easily be turned off if inflation rises. Doves like open-ended purchases because of the potential to promise they will continue until the economy gets better. ... A simple pledge of month-to-month purchases with no guidance on how long they will continue is unlikely to satisfy the main decision makers on the FOMC. They rejected open-ended purchases in favour of a $600bn QE2 in November 2010 because they wanted to send a clear signal to the market. If no condition can be agreed then a similar lump sum programme is likely again. We have no idea what will happen today, but at this point the only action that would surprise us is no action. There's been much talk that a bold move today risks being seen as too political given the approaching US presidential election, but we suspect it won't make much difference to the Fed's deliberations. For one thing, even a decision to delay for fear of looking political is itself a politicised decision. But more importantly, Bernanke has likely gone too far in the direction of hinting at further action only to postpone again. As Robin points out, it's a mystery just how innovative the FOMC is prepared to be. But if the Fed does choose to tie policy to economic outcomes, then this meeting will have significant consequences for the future of monetary policy. Below we run briefly through a list of possible outcomes from today's meetings, some complications for each, and a few additional items that we'll be looking for. Much of what we wrote in response to the minutes of the last meeting still applies. 1) Unsterilised asset purchases (QE3) Will they be open-ended? If so, to which specific economic outcomes will they be tied? Will the programme resemble the Evans Rule (keep policy accomodative until either unemployment moves below 7 per cent or inflation rises above 3 per cent)? If not, how big will the programme be? How will newly announced purchases be split between agency MBS and Treasuries? Remember that focussing on agency MBS would both target the housing market and also avoid entanglements with the ongoing Operation Twist, more on which below. 2) Extending the "rate exceptionally low" language guidance into 2015 Robin has an important reminder: Late 2015 seems more likely. Mid-2015 would simply restore the duration of the forecast from the start of this year and so would not imply easing. Also, the Fed might look for some way to make it clear in the statement or the presser that extending the guidance is a proactive rather than a reactive measure. The signal should be that rates will be kept low even if the recovery begins to accelerate and, perhaps, inflation climbs above target; the signal should not be that rates will be depressed through 2015 because the economy is likely to remain weak until then. If included in the statement, then getting the language right on this will be tricky. But if successfully conveyed, this would reinforce the point that 2 per cent is indeed a symmetric target rather than a ceiling, on which the Bernanke has been unconvincing. See our earlier post about this. 3) A change to Operation Twist Twist has pushed up GC repo rates this year by contributing to the stockpiling of short-term USTs on dealer balance sheets. This has helped ease early strains in money markets by increasing the amount of collateral available in repo markets. But RBC analysts noted a couple of possible benefits to scaling back Twist in a note earlier this week: Twist has always been problematic from a policy perspective, and those issues will become much more intense once QE starts. And if the Fed launches QE3, reserves will start drifting toward $1.75 trillion. Continuing to sell Treasuries would create the awkward signal that reserves created by MBS purchases are OK but reserves created by Treasury purchases are bad. If the Treasury sales were going to make it easier for the Fed to drain reserves when the eventual tightening comes, then Twist would be justified. But selling short Treasuries simply means the Fed has lost its ability to mature Treasuries off of its portfolio in the coming years. The only impact on the eventual drain from Twist is the Fed is no longer rolling some of its maturing holdings into 7s, 10s, and 30s. But this impact is tiny relative to the difficulty created by Fed purchases of long duration assets. In addition, stopping Twist would allow the Fed to announce a larger QE. If the Fed stops buying $45bn of long Treasuries per month through twist, it could upsize its QE3 program by $45bn and not have any additional strains on the market. There are certain audiences that would prefer a large sounding announcement even if the actual purchases are no larger. The last point seems a bit overstated, but it's something to keep in mind. 4) Lowering interest on excess reserves This was discussed more seriously within the Fed after the ECB lowered its own (equivalent) deposit rate to zero, though the two systems aren't perfectly analogous. An actual change is unlikely to be announced at this meeting, but it might be further discussed. A small reduction, say, by 5-10bps isn't outside the realm of possibility, but an outright elimination of IOER can be safely ruled out. We've said just about all we have to say on this topic. 5) Changes in the FOMC's economic projections (out at 2pm) The projections for GDP growth this year have actually shifted a bit this year - increased at the April meeting, softened in June - and may yet be changed again. It will also be interesting to see if headline inflation projections for this year are also higher given the recent rise in energy prices. The Woodford paper Made a big splash at Jackson Hole because of its author, and has reinvigorated the debate over NGDP level targeting. There's a good chance Bernanke will be asked to comment on the paper during the presser. Details on the potential costs of unconventional measures We had a lot of questions about this earlier in the summer, but since the last meeting Bernanke has twice indicated that the market functioning costs of further asset purchases should be manageable - first in the minutes to the last meeting, and then at Jackson Hole, where he said: At the same time, the costs of nontraditional policies, when considered carefully, appear manageable, implying that we should not rule out the further use of such policies if economic conditions warrant. But, other than a reference to a Fed staff presentation in the minutes, we still don't have much detail on why he now feels better about this than he did earlier in the year or even a clear sense of what he was worried about; perhaps someone will ask him. Other weirdo ideas Won't happen, but just to be comprehensive, we'd remind you that a couple of interesting fringe-y ideas (but by serious people) that we've come across recently are an MBS/Treasury swap and an MBS version of Twist. This entry was posted by Cardiff Garcia on Thursday, September 13th, 2012 at 9:29 and is filed under Capital markets. Tagged with ben bernanke, FOMC.