Goldman On What To Expect From Tomorrow's Fed Announcement

With the expanded two-day FOMC meeting (which until 45 days ago was supposed to be just one day) set to start shortly, here is chief policy maker Goldman Sachs reiterating again how much futile loosening to expect from the Fed. Nothing new here: Goldman repeats its call that Twist will hit tomorrow (and in a following report MS reiterates its call for Torque), sees IOER being cut from 0.25% to 0.1%, (sending the money and repo markets into a tailspin), but stops short of demanding another major round of LSAP. Basically, anything short of this will crash the market; anything long of this (as Rosenberg predicts) including several hundred billion in outright bond purchases, sends risk and gold soaring, and the dollar plunging.

From Goldman: FOMC preview.

  • Although not a done deal, we see a high probability that the FOMC will announce further easing steps at the conclusion of this week’s meeting (September 20-21). The committee put an easing bias in place at the last meeting, and Fed communication—the August FOMC minutes, Chairman Bernanke’s Jackson Hole speech and a number of press reports—has signaled that easing options will be discussed. Moreover, after a two-day meeting, the Fed will be technically prepared to take action.
  • A change in the composition of the Fed’s balance sheet—“Operation Twist”—looks very likely. However, there is still considerable uncertainty about the size and maturity mix of the sales and purchases. As a complementary measure, we also expect that the committee will announce a cut in the interest on excess reserves (IOER) rate to 0.1% from 0.25%, although this is a much closer call. An IOER cut would lower market interest rates a small amount and could aid communication.
  • We see low odds of a change in the Fed’s communication of its policy objectives, a proposal supported by Chicago Fed President Evans and others. This is a complex and somewhat controversial idea, and likely requires further discussion. There also appears to be little appetite on the committee for an outright expansion of the Fed’s balance sheet.
  • The easing tool the Fed used last year—balance sheet expansion—does not look like a realistic option for the upcoming FOMC meeting. The Wall Street Journal reported that this tool “doesn't have strong advocates inside the Fed now”, and otherwise it has been conspicuous by its absence in recent press reports. The Fed may ultimately decide to move in this direction, but we see little chance that this will happen on Wednesday.

Although not a done deal, we see a high probability that the Federal Open Market Committee (FOMC) will announce further easing steps at the conclusion of this week’s meeting. Several factors argue for action now rather than later. First, the FOMC put in place an easing bias at the last meeting when it said it had “discussed the range of policy tools available to promote a stronger economic recovery … and is prepared to employ these tools”. Our research finds that an easing bias at the previous meeting is a strong signal about action at the following meeting (see Sven Jari Stehn, “The Likelihood of Additional Fed Easing.” US Economics Analyst, September 9, 2011). Second, Fed communication—the August FOMC minutes, Chairman Bernanke’s Jackson Hole speech and a number of press reports—has indicated that easing options will be discussed. Third, the Fed will be technically prepared to use most of its remaining tools. Many of the options likely to be discussed have been around for a while—a change in the composition of the balance sheet was debated as far back as 2003, for instance—, the staff has had time to assess these tools further since the August 9 meeting, and the committee will now have two days to finalize details. Our model-based probability of easing at this week’s meeting is 75%, and we would subjectively put the odds even higher.

Measures of core inflation have recently accelerated—the core CPI reached 2.0% year-over-year in August—but we do not believe this will stand in the way of easing at the meeting. Fed officials have made clear that they expect inflation to cool as the effects of a rise in commodity prices and supply-chain disruptions in the auto sector wane. Moreover, wage growth has been soft, survey-based measures of inflation expectations are stable and inflation breakeven rates in the bond market have actually declined (though in part this may reflect “twist” expectations).

Recent press reports have signaled Fed officials are considering three specific easing options:

1. Change in balance sheet composition. This policy option is the single most likely step at this week’s meeting, in our view. It has been dubbed a new “Operation Twist” after a similar Fed program in the 1960s. We believe the Fed will announce outright sales of short-term Treasuries coupled with purchases of longer-term Treasuries in order to lengthen the average maturity of its securities portfolio. Minutes from the August FOMC meeting signaled that active turnover of the balance sheet—sales and purchases—was the option under consideration, rather than the smaller and more passive step of reinvesting ongoing purchases related to MBS reinvestment further out the curve (though this would likely accompany the “twist”). If the FOMC announced only a shift in the maturity of MBS reinvestment flows we would consider it a significantly smaller-than-expected ease.

While an announcement along these lines appears very likely, we still see considerable uncertainty about the precise size and composition of the “twist”. The Fed owns $266bn Treasury notes and bonds that mature before the end of June 2013—over the period during which it has signaled to keep rates exceptionally low—and another $232bn that mature over the following year. We expect the Fed to sell some portion of these holdings—perhaps $300bn or so—and purchase securities with 7 to 30 years remaining maturity (we believe the purchases will likely have the same face value as the sales, even if dollar cost differs, because of the way the Fed has traditionally accounted for its security holdings). The total amount of sales and the maturity composition will determine total amount of duration risk likely to be removed from the private sector. We expect the “twist” to amount to net purchases of $300-400bn 10-year equivalents (i.e. the same amount of duration risk as $300-400bn of the current 10-year note).

For more detail and conceptual background on how the twist could work, see our two earlier articles on this policy option (“For More Easing, Will Fed Go Big or Go Long?” US Daily, August 15, 2011; and “Doing the Twist.” US Daily, September 8, 2011).

2. Cut in interest on excess reserves (IOER) rate. Although it is a much closer call, we also believe the FOMC will announce a cut in the IOER rate—the rate the Fed pays banks for their excess reserve deposits. As discussed in an earlier US Daily, the decision comes down to a cost/benefit calculation, and to date the Fed has implicitly decided that the modest potential benefits from an IOER cut have been outweighed by potential costs and risks. The costs of this option mostly relate to money market functioning: 1) it could impair the normal functioning of the federal funds market; 2) lower rates may interact in perverse ways with deposit insurance fees; and 3) an IOER cut could make it challenging for money market mutual funds to cover their operating costs (for more details, see “Revisiting the Rate on Reserves.” US Daily, September 13, 2011).

Despite several potential costs and/or risks associated with cutting the IOER rate, we believe a majority of the committee could support it. While the benefit in terms of monetary stimulus would be small, it would complement the Fed’s other easing actions—the 2013 commitment language and the “twist”—and could aid communication. Moreover, many of the problems associated with an IOER cut are longer-term in nature. Having signaled that it is likely to keep rates low for at least two years, the Fed may put little weight on these concerns. In order to mitigate some of the associated costs, we believe the committee would cut to 0.1% instead of zero.

3. Change communication about policy objectives. Another policy option that has received increased attention lately would tie the FOMC’s rate commitment language more closely to economic conditions, in order to bring greater clarity to the central bank’s goals and intentions. For example, Chicago Fed President Evans has proposed a commitment to keep the federal funds rate at its current level until the unemployment rate has fallen to 7%-7.5%, provided core inflation does not exceed 3%. The Wall Street Journal reported this morning that Chairman Bernanke has asked Presidents Evans and Plosser and Vice Chair Yellen to explore the idea further, but that “the issue about clarifying goals is unlikely to be resolved at this week's meetings, if at all, because of the wide range of views at the Fed about how to proceed” (“Fed Ponders Jobs, Inflation Targets.” September 19, 2011).

There are some good reasons why the Evans proposal is controversial (“The Evans Proposal to Rebalance the Fed’s Dual Mandate.” US Daily, September 7, 2011). First, it may be perceived as an increase in the Fed's long-term inflation target, which could raise inflation uncertainty and reduce economic efficiency (these were the reasons Chairman Bernanke argued forcefully against lifting the Fed's long-term inflation objective in his 2010 Jackson Hole speech). Second, higher inflation expectations would almost certainly increase the nominal long-term interest rate. In most economic models, growth and other asset prices depend only on real rates, but in practice there are some good reasons to believe that nominal rates matter too. For one thing, many financial institutions assess a borrower's creditworthiness on the basis of their (nominal) debt service-to-income ratio. This metric deteriorates with an increase in nominal interest rates, even if real interest rates are unchanged.