Fed Announces No Policy Changes, but Appears Poised to Engage in Further Easing

Yesterday the Federal Reserve’s Open Market Committee released its statement for its most recent meeting.  As expected there was no change in monetary policy. The Fed will continue “operation twist” and maintained its commitment to keeping the federal funds rate low through mid-2013. The Fed also reiterated that it is “prepared to employ its tools to promote a stronger economic recovery in a context of price stability”.

The Committee also said that recent information “suggests that the economy has been expanding moderately, notwithstanding some apparent slowing in global growth”.  They also noted that “while indicators point to some improvement in overall labor market conditions, the unemployment rate remains elevated”.  Finally, they said that “inflation has moderated since earlier in the year, and longer-term inflation expectations have remained stable”.

For two months now, I’ve speculated that the Fed is laying the groundwork for a third round of quantitative easing (QE3). Many have guessed that the Fed will purchase more mortgage-backed securities, which would drive mortgage rates to new record lows.  Whether or not the Fed decides to engage in more asset purchases is dependent upon a number of factors. The first factor is inflation. If inflation starts to escalate, the Fed is going to be loathe to take any action that might exacerbate the increase.  As of now, it appears that inflation is under control.

The second factor is the U.S. economy.  Recently, U.S. economic numbers have been improving, and the Fed notes that our economy is expanding “moderately”.  If our economy continues to show strength, it is unlikely that the Fed will engage in further easing.

The third factor is the situation in Europe, which is the real wild card. It is nearly impossible to tell what is going to happen in Europe, and news and rumors have caused significant market volatility over the past several months.  As of now, it looks unlikely that the Europeans will find some way to deal with their debt problems.  If there is further destabilization in Europe, the impact in the United States could be substantial.  As the committee notes, “strains in global financial markets continue to pose significant downside risks to the economic outlook”. Deterioration in Europe could plunge the U.S. economy back into recession, which would probably cause the Fed to take action.

Several of the Fed members have suggested in recent speeches that the Fed could engage in additional easing. In particular, Fed Governor Daniel Tarullo stated that:

“I believe we should move back up toward the top of the list of options the large-scale purchase of additional mortgage-backed securities… A large-scale MBS purchase program has many of the benefits associated with purchases of longer-duration Treasury securities, such as inducing investors to shift to other assets, including bonds and equities. But it could also have more direct effects on the housing market. By increasing demand for MBS, such a program should reduce the effective yield on those MBS, which in turn should put downward pressure on mortgage rates. The aggregate demand effect should be felt not just in new home purchases, but also in the added purchasing power of existing homeowners who are able to refinance.”

Along the same lines, New York Federal Reserve President William Dudley remarked:

“I don’t think the Fed has run out of bullets.  It’s possible we could do another round of quantitative easing, we could do quantitative easing round three.

The next meetings of the FOMC occur on January 24-25 and then again on March 13.  If there is going to be further easing, I would expect it to be announced at one of these meetings.