Thursday, December 13, 2012

The Fed Announcement

Bernanke should become a Bond villain after he retires.

Ben Bernanke announced that the Federal Reserve will be taking more aggressive action to stimulate the economy. In a nutshell, he got the majority of the Federal Reserve to be much more specific about what they were going to be doing. The biggest change here is that it sets precedent for future action.

QE1 & QE2 (2008 - 2011): "In order to get unemployment down while not letting inflation get out of control, the Federal Reserve will be purchasing $X amount of assets over Y number of months while holding interest rates near the zero bound for the foreseeable future. At that point, the program will end and we will reassess whatever further action needs to be taken."

QE3 Original (Early 2012): "In order to get unemployment down while not letting inflation get out of control, the Federal Reserve will be purchasing at least $X amount of assets per month for at least Y number of months while holding interest rates near the zero bound for the foreseeable future. The program will be extended as long as it needs to be and then it will be wound down accordingly."

QE3 Revised (Late 2012): "As long as unemployment is above 6.5 percent and inflation is below 2.5 percent, the Federal Reserve will be purchasing at least $X amount of assets per month for at least Y number of months while holding interest rates near the zero bound during that same duration. The program will be extended as long as it needs to be and then it will be wound down accordingly."

The biggest change here is an intellectual shift, not a policy one, because committing to specific targets and thresholds signals to the market exactly what would make the Federal Reserve change course. The necessity of such a commitment is because there will be significant turnover of the members serving on the Federal Reserve Board over the next two years. This action sets a precedent, as well as guidelines for future action, which future members are more likely to follow. Before this, action was decided upon on a month-to-month basis (aka "they were making it up as they went along"). 

The leading monetary economist/theorist in the field, Michael Woodford, recommended this policy to the Board earlier this year. He wishes that the Board set a lower target for unemployment and a higher threshold for inflation, but considers the move a step in the right direction. 

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