-No Action on Thresholds Expected Until Well Into 2013

By Brai Odion-Esene

WASHINGTON (MNI) – There appears to be unanimous agreement among Fed
watchers that the Federal Reserve will replace its $45 billion maturity
extension program with a program of similar size to buy long-term U.S.
government securities when the policymaking Federal Open Market Committee meets
next week.

However, they believe the Dec. 11-12 meeting comes a bit too soon for the
Fed to agree on the use of economic variables as thresholds to guide monetary
policy.

And while the market will awaits the all-important November jobs report set
for release Friday morning, economists say the effects of Hurricane Sandy will
loom large in the data, taking employment growth off its recent trend to the
extent that it is unlikely to factor much in Fed’s decisions next week.

“I think the Fed is sufficiently nervous about the economy in the face of
all the fiscal uncertainty posed from the cliff,” Deutsche Bank Chief U.S.
Economist Joseph LaVorgna told MNI, so there is a high likelihood that the
program referred to as “Operation Twist” will be replaced with an outright
Treasury purchase program when it expires at the end of the year.

“The issue will simply be how big a duration program is it,” he added, as
he expects the $45 billion operation twist program to be replaced by a
Treasury-buying program of similar size.

So the Fed will be buying each month, in one form or another, $80 billion
to $85 billion mortgage-backed securities and government debt from now until at
least the third quarter of next year, LaVorgna said, “until the economy has – in
their mind – made it quite evident that it doesn’t need the Fed’s support.”

Michael Gapen, Barclays senior U.S. economist and Asset Allocation
strategist, told MNI that he has long expected the Fed to convert Twist into an
open-ended purchase program.

“It would be a net balance sheet expansion of $85 billion a month beginning
in January,” he said, $40 billion in MBS and $45 billion in Treasuries.

Credit Suisse Economist Dana Saporta also said she expects the Fed to
continue outright purchases into 2013, again split between $40 billion in MBS
and $45 billion in Treasuries per month.

In a speech in Little Rock, Arkansas Monday, St. Louis Federal Reserve Bank
President James Bullard, who will be a voter on the FOMC next year, argued
against replacing the expiring monthly Treasury bond purchases under Operation
Twist with outright purchases of long-term Treasury securities on a one-for-one
basis.

He estimated that about a $25 billion monthly pace of Treasury purchases
would keep monetary policy “on an even keel,” as the economic outlook “hasn’t
changed that much.”

LaVorgna agreed economic conditions are not that bad, and accused monetary
policy of hurting, rather than helping, the recovery. “The Fed constantly
telling you that it’s not moving rates for some period of time has, I think, in
some ways talked the animal spirits down.”

Still, he noted that the central bank has a proclivity, when it is
contemplating doing more vs. doing less, to always do more. In addition, the
market expectation is so strong at this point, that the Fed does not want to run
the risk of disappointing and turning market conditions in the other direction.

“If you’re all in … you are not going to debate whether we should do $20
billion vs. $40 billion; you’re just going to do the $40 billion,” he said.

And while Gapen said while there is the possibility the Treasury purchases
could be reduced to $40 billion, which would not make a major difference from a
macro point of view, “scaling it down to $25 billion would go against, at least,
what they’ve said they wanted to do in the September (FOMC) statement and what a
majority of the other FOMC participants have said since then.”

Credit Suisse’s Saporta said the scale of the Fed’s action depends on
whether the costs are outweighing the benefits. “They have not seen great
evidence of these costs, and they do believe that they are getting some effect
on interest rates – which in their view is helping the real economy,” she said.

The U.S. Labor Department will publish the November nonfarm payrolls report
Friday, but there is general agreement that it will have little bearing on the
FOMC’s decision next week.

Saporta said given the Hurricane Sandy-related quirks likely to be in the
report, plus the looming “fiscal cliff”, “I don’t think the Fed is going to rock
the boat by stopping its asset purchases at this point.”

Gapen, however, said officials in favor or opposed to additional asset
purchases could try and use Friday’s data to press their case.

“I wouldn’t be surprised if one side or the other picks up on a number and
tries to shade it their way, that’s what politicians do,” he said.

He added that if nonfarm payrolls grow by the amount Barclays projects,
50,000 to 55,000, mainly due to the effect of Sandy, “no view should be taken
from this number about the overall health of the job market. We would expect
that it would rebound towards previous levels in the August-September time
period.”

“We would say look beyond this Friday’s number, it should be highly
distorted because of the hurricane and we would expect a rebound in the next
month,” Gapen said.

The last time the FOMC met was in October, and the minutes from the meeting
show policymakers voiced a preference for economic variables in the forward
guidance on how long they expect to keep short term interest rates close to
zero, as opposed to a calendar date, using either quantitative or qualitative
threshold values for inflation and unemployment.

However, no decision was reached as committee participants favored one
approach or the other, and identified further steps necessary before any
implementation.

“I still think there’ll be enough disagreement that they’ll wait to do it,”
LaVorgna said, adding “I think they’ll probably wait till January or March.”

The question is complicated enough that the FOMC will not be ready by next
week to specify economic thresholds, Saporta said, and expects the decision to
be shelved until the FOMC’s March meeting, when Fed Chair Ben Bernanke gives his
first news conference of the New Year.

“If you or I hear of them adding a press conference onto the January
meeting, that could be a signal,” she said.

The FOMC’s first meeting of 2013 will be Jan. 29-30.

Gapen agreed it is too soon for Fed officials to thrash out an agreement
over thresholds, as there remain a whole host of issues that they have to decide
upon, everything from a consensus forecast to qualitative vs. quantitative
targets, and whether they will be thresholds or actual triggers.

“It doesn’t seem to us that there’s a sufficient closing of the gaps
between committee members right now to suggest that they are ready to do it,” he
said. “We think that those discussions will be ongoing well into next year.”

It is a challenge to specify thresholds, Saporta said, but noted that they
will not be policy triggers, meaning even the unemployment and inflation rates
where reached, it does not necessarily mean Fed policy will be tightened.

“It would just raise the conversation,” she said.

LaVorgna said in some ways all this increased transparency actually hurts
the Fed’s flexibility.

“There’ll be times when you might hit certain thresholds, but if your
outlook is changing you may not want to be forced to follow-through on your
pre-commitment for another set of reasons,” he said.

–MNI Washington Bureau; tel: +1 202-371-2121; email: besene@mni-news.com

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