Fed targets a surprise but does not signal policy shift

Wilkinson breaks down Fed announcement

Andrew Wilkinson, chief economic strategist for Miller Tabak & Co., calls the Federal Reserve’s statement following the December Federal Open Market Committee (FOMC) meeting “something of a surprise.”

While the Fed was expected to add to its bond buying plan to coincide with the end of Operation Twist, they also announced parameters necessary to end QE and its zero rate policy and move into tightening mode. The Fed set a 6.5% target for unemployment and a 2.5% target for inflation, pledging to maintain its policy of buying bonds and keeping interest rates low until unemployment moved to its target so long as inflation remained no more than half percent above its 2% target, according to Wilkinson.  

Commenting on the change in policy targets to economic-based indicators in the post-FOMC press conference, Federal Reserve Chairman Ben Bernanke said, "We think it's a better form of communication. The date-based guidance served a purpose, but that was a non-transparent process...Our guidance needs to be viewed as credible. As such, we will refer to publicly available reports and information.

Wilkinson notes that “the Fed was dovish on inflation stating that it remains anchored and is expected to remain low over the two-year horizon.”

Equities continued to rally after the announcement, though Wilkinson discounted the market view that it was a sign of an earlier exit. While acknowledging that bonds and stocks seem to be pushing that view, Wilkinson notes, “Perhaps they are trading on a more aggressive Fed, or more simply there is still pent up demand for riskier assets heading into year-end. Bond prices are now weakening, but not as quickly as post QE3 announcement.”

Wilkinson notes that the Treasury market is not giving a clear picture of the level of inflation fear as the short-end of the curve is seeing slightly lower yields, with the long end showing higher yields.

He adds, “Of special interest will be how hard the Fed keeps its foot on the bond-buying pedal as it approaches its unemployment target, which at the last count remain still two years away. Will they ease up on the volume of bond purchases when the unemployment rate stands at 6.9% compared to today’s 7.7%.”

In its post-meeting statement, the Fed pledged to continue buying Treasuries at the same pace as it had, despite Operation Twist officially coming to an end at the end of the month. Speaking on that topic, Bernanke said, "This is a continuation of what we said in September. In September we expressed dissatisfaction with the labor market...The amount of stimulus is more or less the same, it's just a continuation from what we said in September."

Despite the surprising nature of today's announcement, Wilkinson concludes, "Today’s adoption of official targets for inflation and unemployment has not caused a shift in the FOMC’s timetable for policy removal."

A topic of particular concern throughout the post-meeting press conference was the looming fiscal cliff and how the Fed would react should policymakers fail to come to an accord. "If the fiscal cliff occurs, the Fed doesn't have the tools to combat such an event," Bernanke said. "We would try to do what we could, but we cannot offset the impact [of going over the cliff]."

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