FOMC Preview: Expiration, Extension, And 'Evans' Rule
At the top of the agenda for today’s FOMC meeting is deciding what to do about the Maturity Extension Program (MEP). SocGen agrees with consensus (as we noted the day QE3 was announced means a ~$4tn Fed balance sheet is on its way) that the MEP (Twist) will be converted into outright QE. The size is more uncertain, but we see several reasons why the current pace of $45bn/month should be maintained (which combining with the $40bn MBS means the Fed’s balance sheet is expected to increase by $85bn/month from January onwards). There has been no “significant” improvement in the outlook for employment (recent data is likely to be played down by Bernanke). Scaling back monetary accommodation also seems at odds with the looming fiscal contraction which could dampen growth in early 2013, which SocGen suggests will lead to the FOMC’s economic forecasts being updated (and downgraded we suspect) as the 2013 GDP forecast of 2.5%-3.0% looks too high in the context of contractionary fiscal policy and is at risk of being revised down. As for the “Evans Rule,” we believe that it will be adopted eventually, but don’t expect an announcement for now.
Deciding what to do about the Maturity Extension Program which is set to expire at the end of the month will top the agenda at today’s FOMC meeting. At December 31, the Fed will have no short-term Treasury holdings left in its portfolio; hence extending the program is not an option. We believe that the Fed will opt to continue buying Treasuries outright and finance the new purchases by increasing excess reserves. In other words, the growth of the Fed’s balance sheet will accelerate from the current pace of $40bn/month.
There is strong consensus that Treasury purchases will continue beyond December. The size, however, is more uncertain. Our own expectation is that the Fed will continue buying at the long end of the curve to the tune of $45bn/month. This view was challenged last week by St Louis President Bullard who suggested that the pace could be scaled back to $25bn/month. His rationale was that outright QE is more simulative than the twist, allowing the Fed to buy fewer Treasuries while still providing the same amount of accommodation. However, we see several arguments against scaling back the size significantly below $45bn.
1. Market is priced for $45bn. A Reuters survey of primary dealers conducted last Friday found a median forecast of $45bn. Therefore any meaningful reduction in the monthly run rate would likely induce an unwarranted backup in bond yields. This would constitute a de facto tightening, which seems counteractive to the Fed’s objective of being very accommodative at this stage of the cycle.
2. Labor market is still not strong enough. In various communications, the FOMC as well as individual Fed officials have stated that a reduction in the pace of buying is conditional on a “significant improvement in labor market conditions.” Chicago Fed President Charles Evans suggested this past week that a significant improvement means at least six months of job gains in excess of 200,000, confirmed by above-trend GDP growth. We are clearly not there yet, particularly on GDP which is tracking just above 1% for the current quarter. While Evans was expressing his own view, we believe that his position is closer to the Fed’s governors than Bullard’s.
3. Downside risks around the cliff. Moreover, with the fiscal cliff looming, the downside risk on GDP extends into Q1. Given the significant probability of a fiscal contraction, we believe that a smoother path for monetary policy would be to announce a larger program now and scale it back later if necessary, rather than reducing the size of Treasury purchases today only to increase them again in early 2013.
4. FOMC 2013 forecasts could see another downgrade. At the conclusion of next week’s meeting, the FOMC will also publish its new economic projections. The Fed’s 2013 GDP forecast published in September still looks relatively high at 2.5%-3% (see Table 1) and is at risk of being revised lower. Although the revision is unlikely to be large, the direction also argues against scaling back Treasury purchases and could in fact be used as a support for continuing at $45bn/month pace.
Combined with the MBS purchases which are also expected to continue at their current pace, the Fed’s balance sheet is expected to increase by $85bn/month from January onwards. If these run rates are maintained through the end of 2013, as is our central expectation, the Fed’s balance sheet would increase by $1tn over the next 12 months.
In addition to a decision on Treasury purchases, the FOMC also appears to be moving closer to a decision on the so-called “Evans Rule.”
Under the rule, the calendar guidance would be replaced with economic conditions based parameters tied to the level of unemployment and to the outlook for inflation. This has been a topic of extensive discussions by the FOMC and according to Bernanke, the talks have been promising. Evans has recently revised his 7%/3% plan to 6.5%/2.5%, moving closer to Kocherlakota’s proposed thresholds of 5.5%/2.25%. The movement towards the middle suggests that the committee may be getting closer to reaching a compromise. While we cannot exclude the possibility of an announcement today, we believe that the more likely timeframe for adopting quantitative thresholds is Q1 2013.
Even if the rule is not officially announced next week, it may be useful to view the FOMC’s new economic projections in the context of the proposed quantitative thresholds. Of particular interest should be the terminal point of the unemployment rate trajectory and when it crosses the 6.5% threshold.
Based on the September forecasts, the new Evans rule would trigger the first rate hike no sooner than 2015 which is in line with the current calendar guidance.
We don’t expect that the terminal forecast for unemployment will change materially next week as any downward revision to the GDP path will be mitigated by a lower starting point for unemployment.
Source: SocGen, BofAML, and Bloomberg
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