Fed Doubles Down
by Brian S. Wesbury and Bob Stein
Issue 218– December 26, 2012
First, the Fed decided to convert Operation Twist into an outright expansion of its balance sheet. Since September 2011, the Fed has been buying $45 billion per month in long-term Treasury securities and, at the same time, selling $45 billion in short-term securities. Once this program ends at the end of December, the Fed will keep buying the long-term securities but stop selling the short-term ones.
This is not some cosmetic change. Unlike Operation Twist, which shifted the composition of the Fed’s balance sheet (more long-term, less short-term), the new program will expand the size of the balance sheet. If the Fed does it for all of 2013, it will add about $540 billion to a balance sheet that is now $2.8 trillion. Meanwhile, the Fed will keep buying $40 billion per month in mortgage securities, so we’re on a path for a balance sheet of nearly $4 trillion by the end of next year.
We don’t like the change. The extra expansion of the Fed’s balance sheet is not going to help the economy. The vast majority will simply add to excess reserves in a banking system that’s already overstuffed with $1.4 trillion in excess reserves. Banks, knowing the Fed will eventually retract this liquidity are not eager to lend it out. When nominal GDP – real GDP plus inflation – is consistently growing at a 4%+ annual rate, a federal funds rate of nearly zero is unsustainably low. Monetary policy is already too loose. Policymakers need to focus on fiscal and regulatory obstacles to growth, not a supposed lack of monetary accommodation.
The second big change by the Fed is the removal of a specific timeframe for keeping rates at essentially zero. As recently as the October meeting, the Fed was saying it would keep rates at current levels through mid-2015. Instead, the Fed introduced economic guideposts to signal when it will start changing short term rates. These include an unemployment rate at or below 6.5%, an inflation forecast (by the Fed) of 2.5% or more, or an unmooring of inflation expectations. In addition, the Fed says it will also look at other measures of the labor market, inflation pressure, and the financial markets. Note that the Fed’s most important inflation measure is its own projection of future inflation, not actual inflation. In other words, higher inflation, by itself, won’t mean higher short term rates, unless the Fed thinks higher inflation will be persistent.
Notably, the Fed also issued a more pessimistic set of economic projections than it previously released in September, reducing the real GDP growth rate for 2012-15 by about 0.1 percentage points per year. Despite the fact that the unemployment rate in recent months has declined faster than the Fed anticipated, it thinks the jobless rate will end 2014 at or slightly above where it previously thought. Taking these projections at face value, as well as the Fed’s projections for inflation, suggests the consensus view at the Fed is the federal funds rate will not have to rise until the third quarter of 2015. This is consistent with its previous guidance of staying where they are until at least mid-2015. By contrast, plugging the First Trust forecast of the unemployment rate into the Fed’s framework suggests the first rate hike will come in the third quarter of 2014, about a year earlier than the Fed now anticipates.
Other, more minor, changes to the statement include the following.
(1) Adding an assessment of employment into the very first sentence of the statement, showing how focused the Fed is on the labor market.
(2) Removing a reference to the housing market coming back “from a depressed level,” suggesting the Fed thinks the housing recession is getting further away in the rear view mirror and is less relevant to the economy today.
(3) Inserting a reference to monetary policy staying accommodative for a considerable period “after the asset purchase program ends.” In other words, the Fed will stop expanding its balance sheet before it starts raising rates.
It also reiterated that it will “closely monitor” the economy and financial markets to gauge whether it should continue asset purchases or even expand them.
Once again, the lone dissent was from Richmond Fed President Jeffrey Lacker, who opposed both the asset purchase program and the economic guideposts chosen to signal when the Fed will consider raising interest rates.
Like we have been saying for many months, quantitative easing will simply keep adding to the already enormous excess reserves in the bank system, not deal with the underlying causes of economic weakness, including the growth in government spending, excessive regulation, and expectations of higher future tax rates. It will not add anything to economic growth and, as long as banks are reluctant to lend aggressively, not cause hyper-inflation either.
Brian S. Wesbury is Chief Economist and Bob Stein, CFA is Senior Economist at FirstTrust Advisors.