Overview: At the December Federal Open Market Committee (FOMC) there were no policy changes, in line with expectations. Though some data was slightly better in the aftermath of the November meeting—acknowledged by the December FOMC statement—the Fed continued to adopt a cautious tone, prepared to “employ our tools as appropriate to promote a stronger economic recovery, in a context of price stability.” The Fed retained the Operation Twist endeavor, and maintained the pledge that Fed funds target rate would remain at 0-0.25% at least through mid-2013. November meeting minutes revealed extensive deliberation on changes to the Fed’s communication strategy, but offered little guidance on additional easing, other than verbal intervention. No decision to usher in changes to communication strategies was made at the meeting.
Commentary: As expected, the Fed ushered in no changes to the communication policy in December, which will likely wait till January at least. Under the baseline scenario of a still-elevated risk of U.S. recession, expect more QE in 2012 (meaning an expansion of the Fed’s balance sheet). I also maintain that some weakening in U.S. growth in H1 as fiscal drag intensifies and the fallout of the eurozone crisis and global slowdown on the U.S. economy becomes apparent, the economic weakness will be met by easing of Fed policy. Certainly, any rising risk of a destabilizing financial shock from the eurozone would certainly push the Fed toward unconventional easing sooner. In my opinion, the credit channel of transmission is broken, and I think the Fed needs to climb up the unconventional ladder (via purchases of assets other than Treasurys) to keep policy effective. The decision to reinvest the runoff on the MBS holdings into MBS rather than Treasurys in September and recent speeches from key FOMC members should be viewed as supportive for the future balance sheet endeavor to include MBS.