Fed Links Policy to Threshold Unemployment and Inflation Rates
The Federal Reserve ties future monetary policy tightening to specific unemployment and inflation rates and expands quantitative easing.
By Steve Van Order, Fixed-Income Strategist, Calvert Investment Management, Inc.
On Wednesday, December 12, the Federal Open Market Committee (FOMC) announced that it will link future moves to tighten monetary policy to threshold levels of unemployment and inflation.This is a landmark change in how the Federal Reserve (Fed) will communicate expectations for future monetary policy. Since the financial crisis of 2008 to 2009, the Fed had been providing approximate timeframes for its ultra-low interest rates and quantitative easing(QE), so the connection with specific levels of unemployment and inflation will likely remove some uncertainty for financial market participants.
The FOMC also stated that the Fed will buy $45 billion in Treasury securities per month starting in January 2013. This new QE program will take the place of “operation twist,” which ends this month and involves the Fed selling short-maturity Treasuries and using the proceeds to buy longer-term Treasuries.
Fed Further Changes Policy Principles
The 1978 Humphrey-Hawkins (H-H) legislation established the Fed’s “dual mandate” objectives of pursuing policies that create both price stability and maximum employment. But until the recent monetary policy cycle, in practice the Fed focused almost entirely on price stability. In the context of the H-H legislation passage as the U.S. price inflation rate approached its historical high in 1980, that focus was understandable. For about a generation, then, the Fed successfully focused on taming inflation.
Over the last decade, with inflation quiet, the Fed has moved more toward a balanced approach to the two mandate objectives. This move accelerated as a result of the high unemployment and great excess capacity in the economy that the financial crisis created. The FOMC’s January 2012 annual statement of principles and long run goals of monetary policy clarified this pursuit of monetary policy balanced to achieve the two mandate objectives.
In this context, it’s easier to understand the FOMC’s adoption of a 6.5% unemployment rate threshold and a 2.5% inflation rate threshold that, if approached, would increase the probability of a Fed tightening. Chicago Fed President Charles Evans was the first FOMC official to publicly propose such a dual-threshold rule. Importantly, these levels of unemployment and inflation are not targets, but thresholds to help guide market expectations through the next stage of this monetary policy cycle. The Fed still has a 2% long-run target for the core inflation rate but specifies no long-run target measure for the labor market except for a goal of “maximum employment.”
Fed to Buy More Treasuries as Part of QE
In addition to the policy thresholds, the FOMC also announced new Treasury bond purchases that will start in January at a monthly rate of $45 billion. These Treasuries will have an average duration1 of about nine years, which is similar to the net duration result from operation twist. This new QE program is in addition to the $40 billion a month in mortgage-backed securities (MBS) that the Fed already buys. On an annualized basis (not counting reinvestment of principal) these two programs will result in the Fed buying over $1 trillion in government-backed bonds in 2013, which will increase the central bank’s balance sheet to about $4 trillion—nearly 25% of U.S. nominal GDP.
The Fed’s purchases of $1 trillion in government-backed bonds in 2013 will likely create a large negative net supply situation in taxable bonds denominated in U.S. dollars. By removing such a large amount of Treasuries and MBS from the market, the QE initiatives will likely cause investors to continue to move into other types of taxable debt, such as corporate bonds, pushing yield spreads2 narrower in those other asset classes. We also anticipate that the Fed’s QE buying will likely prevent the current very low Treasury yields from moving significantly higher in 2013 and should also dampen interest rate volatility, although there could still be an occasional uptick in volatility.
1. Duration measures a bond’s sensitivity to changes in interest rates. Generally, the longer the duration, the greater the change in value in response to a given change in interest rates.
2. Yield spreads measure the difference in yield between a non-Treasury bond and a Treasury security with a comparable maturity.
This commentary represents the opinions of its author as of 12/18/12 and may change based on market and other conditions. The author’s opinions are not intended to forecast future events, guarantee future results, or serve as investment advice. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Calvert Investment Management, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information.
Calvert Investment Management, Inc., 4550 Montgomery Avenue, Bethesda, MD 20814