August 2012 FOMC: later tightening, but not QE3

Remember the January FOMC meeting?

Try – because I think that it hold the keys to the current FOMC outlook.

If you’ve forgotten, it’s the meeting where Bernanke unveiled the FOMC’s new 2% inflation target.

The way Chairman Bernanke presented the inflation target, and explained how it related to their forecasts, is the clue that the Fed is a strong chance to ease monetary policy this meeting.

At that the Jan FOMC meeting, Bernanke had to balance forecasts the showed the Fed was missing on both sides of their mandate — unemployment was expected to remain high, and inflation sub-2% inflation over the forecast horizon — with the fact that the Fed saw some signs that things were picking up.

The formula he went for was that the committee would take further action if the forecasts were realised. As it turned out, things did pick up (though perhaps that was just seasonal) and the FOMC upgraded in April – and the FOMC held.

Well, that ended pretty quickly. At their June meeting they downgraded their forecasts, and eased monetary policy. Now, following some more weak data, it is likely that the Fed staff have again downgraded their forecasts (though we won’t see the new FOMC forecasts until the September FOMC meeting).

My estimates are for GDP to be cut to below the pace expected in Jan for the unemployment rate to be above the rate expected in Jan and for the PCE forecast to be at or below the pace of inflation that was expected at the Fed’s Jan forecasting round – these revisions will be across the entire forecasting horizon.

So the FOMC is likely to meet with a weaker set of projections than at the Jan meeting, where Bernanke made it clear that the FOMC would ease monetary policy further if their forecasts were correct.

The arguments for waiting and seeing seem weak this time. The global backdrop is much weaker now than in January. It seems clear that ~30% of global GDP is in recession (Europe and the UK are ~30%) and the momentum in the US data is worrying (three consecutive declines in US retail sales is unusual outside of recession).

I do not think it’s accurate to say that the FOMC won’t act as it’s not a ‘forecast meeting’ — Operation Twist was launched at the September 2011 FOMC meeting, and the Fed did a decent enough job of explaining what was going on.

The fact they extended twist last meeting might make them more circumspect – a small step would be to extend their promise to keep rates low out to 2015. At present there are 7 votes for ‘policy firming’ in 2014 and 6 for ‘policy firming’ in 2015. If Bernanke can talk four of those seven into shifting to 2015 (in Jan there were two who saw first ‘policy firming’ in 2016) he ought to be able to move the date back a year.

I think balance sheet expansion is certainly on the table, however given that it’s a policy that’s impossible to switch off, and that there is an intermediate step that’s available, I judge that full balance sheet expansion is only a 35% chance this meeting.