The Fed acts ... just
The Federal Reserve eased monetary policy to boost the flagging recovery, announcing a modest extension of "Operation Twist", that is the purchase of long-term bonds financed by the sale of short-term paper. The stock market initially sold off but has bounced back. In its statement, the Fed said: The Committee expects economic growth to remain moderate over coming quarters and then to pick up very gradually. Consequently, the Committee anticipates that the unemployment rate will decline only slowly toward levels that it judges to be consistent with its dual mandate. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook.The Fed said as a result it would continue to sell off one to three-year bonds from its portfolio and use the proceeds to purchase six to 30 year bonds, thereby putting downward pressure on long-term interest rates. An accompanying statement from the New York Fed said this would result in the purchase of $267 billion of longer term bonds by the end of the year.At $44.5 billion per month, that makes Operation Twist 2 almost identical in size to Operation Twist 1, which wraps up this month, having exchanged $400 billion worth of bonds over nine months. Although this decision was more or less expected, it was still on the minimialist side of available options. Steps that were apparently passed over at today's meeting include: outright quantitative easing (buying longer-term bonds by creating new money), extending the verbal commitment of zero interest rates to the end of 2015 from 2014, buying mortgage-backed securities instead of Treasurys, or announcing a larger or longer Operation Twist. The Fed may have no choice but to consider those options if the economy doesn't improve in coming months. By the end of Twist 2, the Fed will have exhausted its supply of 1-3 year paper. Twist 3 would require it to begin selling some of its still copious supply of 3-6 year bonds ($583 billion as of May 30, according to Macroeconomic Advisers).We will understand the Fed's thinking later today when it releases the economic projections of the Federal Open Market Committee members, and Ben Bernanke, the chairman, holds his press conference. It may be that the Fed really thinks the economy is going to recover on its own without much more of a nudge, or that Europe represents a binary risk and the Fed will know better how to respond when it has more confidence about whether the euro zone will collapse.Final thought: by extending the expiration date of the programme to December 31st, the Fed accentuates the stimulus withdrawal syndrome scheduled to begin on that date. The Bush tax cuts and payroll tax cut expire then, and the sequester of automatic spending cuts takes effect on January 2nd. Should we add a monetary off-ramp to the fiscal cliff?