Fed Likely to Expand QE as Twist Ends, Cliff Looms
Stubborn high unemployment and the looming fiscal cliff challenge give the Federal Reserve all the reason it needs to expand its stimulus efforts when it meets next week, analysts say.
Gathering just before its "Twist" asset-swap operation expires at year-end, signs are that the Federal Open Market Committee will replace it with more outright bond purchases, more "quantitative easing" aimed at lowering interest rates to encourage businesses to invest and hire.
The two-day meeting that opens Tuesday comes after Friday's November data confirmed that the jobs market, the key focus of the Fed, is growing only very slowly.
The unemployment rate fell to 7.7 percent, a still unhealthy level that reflected as much a continuing rise in job market dropouts as it did fresh job creation.
Moreover, FOMC members led by Chairman Ben Bernanke have a worried eye on the Washington battle over the fiscal cliff, the automatic tax hikes and sharp spending cuts that could send the country back into recession if politicians cannot compromise.
With a deadline at the end of the year, the White House and congressional Republicans appeared still far apart on an alternative deficit reduction plan that could avert the cliff.
The Fed's Beige Book survey of regional economies, compiled to help FOMC members decide their direction, last week showed widespread worry among businesses over the standoff.
And in late November Bernanke warned that the cliff's $500 billion crunch on the economy starting from January 1 "would pose a substantial threat to the recovery."
Asked what the central bank could do, he replied: "I don't think the Fed has the tools to offset that."
With its benchmark interest rate already at a bare-bottom 0-0.25 percent since December 2008, the Fed's main policy tool is its bond and mortgage-backed security purchases, through which it has been holding down long-term interest rates.
The cutoff of the Twist, which involves swapping about $45 billion a month in short-term assets with long-term ones, will leave the Fed with only its open-ended QE3 bond purchases in place, worth $40 billion a month.
Signals from a number of individual Fed officials and from the minutes of the last FOMC meeting show support for expanding those purchases to ensure liquidity remains easy.
"We expect the Fed to decide next week that it is not prepared to allow 'Operation Twist' to expire without being replaced," said Nigel Gault at IHS Global Insight.
The replacement purchases -- not swaps -- would likely be around $45 billion a month, taking total Fed action to $85 billion a month, he said.
The record of the last FOMC gathering on October 23-24 showed clear support for added stimulus after the Twist ends.
"A number of participants indicated that additional asset purchases would likely be appropriate next year after the conclusion of the maturity extension program in order to achieve a substantial improvement in the labor market," the minutes said.
Still, support at the Fed for more QE is not unanimous.
Charles Plosser, the head of the Fed's Philadelphia branch and a regular critic of easy money policies, argues that QE and other efforts have not had the impact intended on growth and jobs, and are raising the risk of a return to high inflation.
Arguing alongside him has been FOMC member Jeffrey Lacker, head of the Richmond Fed.
Speaking in November, Lacker argued that there is "ample room for skepticism" about the impact of the Fed's asset purchases, which he said had only an "ambiguous" effect on the economy.
Yet another policy issue facing the Fed is whether to be more explicit in its inflation and unemployment targets for deciding when to tighten monetary policy.
Meeting minutes show this to be an area of contention between a number of FOMC participants, with little conclusion on how it would be implemented.
Analysts said that idea will likely be kicked down the road next week, but could come back in FOMC meetings early in 2013.
"Given the wide disparity of views among monetary policymakers and numerous unresolved issues, we think it is far from clear that the FOMC will replace its use of date-based forward guidance with explicit thresholds in 2013," said Michael Gapen at Barclays.