10/24/12

With Bernanke On The Tight Rope, FOMC Will Expand QE3 In December

8:24 PM

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Central bankers have been flying under the radar ever since the ECB’s Mario Draghioffered Spain and Italy open-ended bond purchases and Fed Chairman Ben Bernankeunveiled a third round of quantitative easing.

Working behind the scenes, Bernanke & Co. have been gathered inWashington for two days and on Wednesday delivered their latest policy decision. The FOMC statement revealed it decided to keep the monetary levers in their current position and is in wait-and-see mode until December, as I reported here.

The real action will come in the December meeting, Goldman Sachs’ chief economist Jan Hatzius believes, where he expects QE3 to be expanded to $85 billion a month to make up for the end of Operation Twist, and the possibility of outcome-based rate guidance. Also in Fed watchers’ minds will be the future of Bernanke. A report suggested the Chairman will end his tenure in January 2014, not seeking a third mandate ifBarack Obama wins and, would be replaced if Mitt Romney is victorious. The FOMC’s statement, released at 2:15 p.m., revealed little on the future pace of policy action. Bernanke’s activist Fed has done enough for the time being. The Fed extended Operation Twist (which puts pressure on longer-term rates by selling short-term Treasuries and buying securities in the farther end of the curve) and then went all in, delivering open-ended QE3. On Wednesday, they stayed their course.

In conjunction with Mario Draghi and the ECB, Bernanke and the FOMC propped up risk assets across the board. In Europe, rattled markets settled and yields on peripheral debt, particularly in Spain and Italy, receded, giving politicians some much needed breathing space. On this side of the Atlantic, equities rallied effervescently, along with gold.

The Fed is currently buying $85 billion in longer-term securities a month, $45 billion of those financed by the Twist with the remaining being poured into mortgage-backed securities via QE. Goldman’s Hatzius believes Bernanke deliver will deliver the good news in December: the Fed will increase its QE program in order to keep the rate of monetary easing steady, the economist noted. Hatzius said:

We believe that the committee will be reluctant to do anything that markets would interpret as a slowdown in the pace of monetary easing, such as an indication that the pace of asset purchases will slow in the foreseeable future. Our baseline expectation is a continuation of the current pace of asset purchases of $85bn per month on an open-ended basis, which would imply that the current $45bn per month in twist-financed Treasury purchases is replaced by $45bn per month in QE-financed Treasury purchases.

Among the more controversial issues, the Fed could tamper with its forward-rate guidance, Hatzius believes. Currently, the FOMC told markets they plan to keep the Federal Funds rate at the zero-range at least until mid-2015. But “nobody really likes it [i.e. calendar-based guidance], that has been true ever since the ‘mid-2013’ language was adopted at the August 2011 meeting,” noted Hatzius.

His team at Goldman is looking at an outcome-based guidance, which they believe FOMC participants favor. A sort of “Evans Rule,” they call it, which would tie interest rate movements to the Fed’s dual mandate. In other words, the FOMC would pledge to keep from hiking rates until the unemployment rate falls below a certain threshold and/or if inflation rises enough.

The Evans Rule does face some obstacles, the major one being that the unemployment rate may not be the best indicator of the employment side of the Fed’s mandate. Factors such as the labor force participation rate and the structural participation rate may give further details as to the amount of slack in the labor force. The Fed could try combining these factors, “[but] this would be very difficult to communicate and would risk introducing substantial volatility into the market’s monetary policy expectations and thus broader financial conditions,” Hatzius explained.

U.S. stock markets zigzagged through the day ahead of the Fed announcement. The three major U.S. indexes were essentially flat in the aftermath of the announcement, with the S&P 500 marginally down and both the Nasdaq and the Dow showing negligible gains by 2:53 PM in New York. Major financials like Morgan Stanley, Bank of America, and JPMorgan Chase were all in positive territory, while gold was down 0.3% to $1,704.70 an ounce.