QE 3.1: The Fed Gets Specific

In September, the Federal Open Market Committee (FOMC) announced a third round of quantitative easing, consisting of purchases of mortgage-backed securities and long-term Treasuries. QE3 represented a break from previous rounds of easing because it did not involve an end date for the purchases. With that modification, there was some speculation that the FOMC would also set inflation and unemployment thresholds after which, if reached, the Fed would wind down its easing policy. This concept was floated by Chicago Federal Reserve President Charles Evans and endorsed by Minneapolis Fed President Narayana Kocherlakota.

Today, the FOMC embraced the so called "Evans rule." Specifically, they announced they would maintain the near-zero federal funds rate at least until the unemployment rate fell to 6.5 percent and projected inflation for one to two years out rises above 2.5 percent. Previous statements since the announcement of QE3 had simply said that easing would be contingent on a substantial improvement in the labor market in the context of price stability. Now, it is much clearer what they mean by "substantial improvement" and "price stability."

Beyond the targets, the FOMC also announced that it would continue to buy mortgage-backed securities at a rate of $40 billion per month while reinvesting maturing securities back into MBSs. They also will continue to buy long-term Treasury bonds at a clip of $45 billion per month even after Operation Twist expires at the end of the year. This means that the overall Fed balance sheet will likely increase faster than it has in recent months.

Source: Cleveland Federal Reserve

During the press conference following the FOMC statement, Fed chairman Ben Bernanke stressed that meeting either the inflation or the unemployment threshold would not automatically trigger a tightening of policy; rather, that would depend on a broader context, especially if one of the thresholds is not close to being met. He also made clear that the 6.5 percent unemployment target was not the FOMC's view of full employment but rather would allow the Fed some room to withdraw its support gradually without risking overheating the economy by being too accomodative.

On fiscal policy, he hoped Congress would do the right thing by coming to an agreement on a deal to replace the fiscal cliff, and hopefully one that does not kick the can further down the road. Bernanke advocated that Congress and the President work to simultaneously avoid creating economic headwinds that could hurt our recovering economy and agree on a framework that could show policymakers are serious about addressing our unsustainable fiscal path. Both were equally important according to Bernanke.

The markets rose quickly after the FOMC announcement, but economic growth in the near term may ultimately depend more on what happens with the cliff. Bernanke has cautioned that the Fed would be unable to prevent the economic downturn created by the fiscal cliff. With clear guidance on monetary policy, lawmakers must come together soon to get fiscal policy right.

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