Conditional: Fed Drops 2015 in Favor of 6.5% and 2.5% (Sonders)

December 12, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• The Fed augments QE3's MBS purchases with even more US Treasury purchases to offset the impact of the expiring Operation Twist.
• Economic targets now take over from calendar targets: instead of promising to keep rates low until mid-2015, the Fed is now targeting a 6.5% unemployment and 2.5% inflation rate.
• During the post-meeting press conference, Fed Chairman Ben Bernanke did concede that there could be unintended consequences of such aggressive monetary easing.

The Federal Open Market Committee (FOMC) departed its final meeting of 2012 with a lot of new news, not all of which was a surprise relative to consensus. Let's get right to the details.

QE3.1

The Fed announced it would expand its quantitative easing asset purchase program ("QE3") in light of the coming expiration of Operation Twist at year-end. During Operation Twist, the Fed was swapping about $45 billion in short-term US Treasuries for an equal amount of long-term Treasuries. In addition to the original QE3 purchase plan of $40 billion in mortgage-backed securities (MBS), the Fed will now buy an additional $45 billion in Treasury securities. Some will refer to this as QE4; but it's more accurately termed QE3.1. This part of the release was largely expected.

From calendar to economic targets

A tad more surprising—although speculation about it had been higher recently—was the effective replacement of the calendar target for the Fed's future plans with economic targets. Recall the Fed's language had been that it was going to keep rates "exceptionally low" until mid-2015—that reference was not in today's statement. Instead, the Fed has now explicitly targeted the unemployment rate and inflation (the Fed's dual mandates).

Specifically, the Fed said interest rates will stay low "at least as long" as the unemployment rate remains above 6.5% and if inflation "between one and two years ahead" is projected to be no more than 2.5%. The committee "views these thresholds as consistent with its earlier date-based guidance." The Fed will also continue reinvesting its portfolio of maturing housing debt into agency mortgage-backed securities and will resume rolling over maturing Treasury securities.

For the eighth consecutive meeting, Federal Reserve Bank of Richmond President Jeffrey Lacker dissented. But the stock market initially had a more-positive perspective before weakness took over into the market's close, while Treasury yields increased slightly.

"Balanced approach"

Aside from the aforementioned addition to its asset purchase program and economic targets, there were other key changes to today's statement versus the one following the October 24 meeting, including an acknowledgement of the improvement in labor conditions/drop in the unemployment rate and lower inflation more recently.

Following the details of the additional asset purchases, the statement noted:

"In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of two percent."

Press conference highlights

Out of the block during the post-meeting press conference, Fed Chairman Ben Bernanke reaffirmed that the Fed's highest priority is job growth, citing the current "waste of economic and human potential." He reiterated that the new economic targets—of unemployment and inflation—are tied to the Fed's rate policy, not its quantitative-easing policy. However, it's likely that QE-related purchases will end prior to the Fed starting to increase rates.

Fed's new central tendency forecasts

Source: Federal Reserve, as of December 12, 2012.

Bernanke also elaborated on the other factors being watched, including employment growth and the labor participation rate. He reiterated that the Fed expects inflation to remain 2% or lower indefinitely. Its projections for real gross domestic product were lowered only marginally, while longer-run projections were left unchanged.

Using the mid-points of the Fed’s updated central tendency forecasts, the unemployment rate would reach its 6.5% target in the second half of 2013, so in the immediate aftermath of the meeting, fund-rate projections did not change significantly. The median funds-rate forecast is 1% by the end of 2015. Only five of the 19 FOMC members expect the first rate hike to occur before 2015, which is the same ratio as last meeting.

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