The bottom line from the Minutes of the FOMC meeting on 20-21 September 2011, is that Operation Twist was regarded by the majority of members of the Committee as the most measured response to the deterioration in the economic outlook and that QE is being kept in reserve in case conditions weaken more markedly because of its greater potency.
The Fed remains very concerned about the economic outlook, with the Minutes repeatedly emphasizing downside risks to growth and the recent increase in domestic and global financial stresses. The Fed seems most worried about the potential for a self-reinforcing negative confidence spiral to develop. The Minutes also stressed that most members saw a need for the FOMC to provide greater clarity about the Fed’s longer-run policy objectives, as well as more transparency about the conditionality of the Committee’s forward policy guidance, though the latter communication change appears more likely. Although the Minutes noted that the staff have revised their near- and medium-term forecasts for the economy down since August, the Fed is still of the view that growth in the second half of 2011 will be stronger than growth in the first half of the year. It is also clear that the FOMC remains internally divided over the appropriate path ahead. While we already knew that Fed Presidents Fisher, Kocherlakota and Plosser dissented from the decision to implement Operation Twist, the Minutes stated that two members thought current conditions warranted even stronger action and supported the maturity extension only as “it did not rule out additional steps at future meetings”.
The diverse views of the Committee were evident in other dimensions of the policy discussion. With regard to increasing the transparency of policy, there seemed to be more support for tying policy to a long-term inflation objective than to the unemployment rate. For example, the Minutes observed that “the long-run level of inflation is determined primarily by monetary policy”, whereas “a number of participants expressed concerns about the conceptual issues associated with establishing and communicating longer-run objectives for the unemployment rate or other measures of labor market conditions, inasmuch as the long-run equilibrium levels of such measures are influenced importantly by nonmonetary factors, are subject to change over time, and are estimated with considerable uncertainty”. There appears to be more support for tying forward guidance to intermediate economic conditions, with the Minutes suggesting that “the Committee’s periodic Summary of Economic Projections could be used to provide more information about their views on the longer-run objectives and the likely evolution of monetary policy”. The Minutes also laid bare a debate about the efficacy of reducing the IOER rate. While lowering the rate could help “signal the Committee’s intention to keep the federal funds rate low”, and a “reduction would result in at least marginally lower market rates and could help stimulate lending”, “reducing the IOER rate risked costly disruptions to money markets”. Most importantly, there was an agreement that more information was needed to “judge its usefulness as a policy instrument in the current environment”. With regard to further balance sheet expansion, that lack of broader support within the Committee in September appears related to the combination of the desire for the Committee to keep its powder dry in case economic and financial conditions deteriorate further over coming months, and that large-scale asset purchases may be “more likely to raise inflation and inflation expectations than to stimulate economic activity and argued that such tools should be reserved for circumstances in which the risk of deflation was elevated”.
Overall, our reading of the Minutes is that while the Fed is deeply concerned about the outlook, the economy and financial stresses would need to worsen noticeably in their eyes before QE is reactivated. Of course, our view is that the Fed’s forecasts are too optimistic and that a significant deterioration is the most likely scenario over the next few months. If we are right, the Fed should adjust its growth outlook during its next meeting in November and the stage should be set for QE to follow in December or January. Finally, it seems that the Fed is quite concerned about its current communications strategy, with many FOMC members expressing the view that policy would be more effective if the Fed were more transparent and clearer about its long-term policy goals and how they related to policy decisions, as well as if their near-term forward guidance were tied to concrete policy objectives. Although the details of a new communication still have to be thrashed out within the Committee, changes appear likely as soon as November. This is most likely to be in the form of attaching numeric economic and inflation goals to the forward guidance.
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BNP Paribas
Corporate & Investment Banking