Fed poised for biggest decision in decades

By Robin Harding in Washington

Published: October 31 2010 22:14 | Last updated: October 31 2010 22:14

This week’s meeting of the US Federal Reserve’s monetary policy committee will be one of the most important in decades as it prepares to launch a new round of quantitative easing.

It will not be a “saving the world on a Sunday night” occasion like the meetings during the financial crisis, but that only adds to its historical significance. The world’s most important central bank is about to use quantitative easing as a routine instrument of monetary policy for the first time.

The goal of QE2 – the nickname for this new round of easing – is to push down long-term interest rates by buying long-term Treasury bonds. On its success rests both the reputation of Ben Bernanke, the Fed chairman, and the chances that the US economy can avoid a decade of weak growth. At this week’s meeting, on Tuesday and Wednesday, the Fed’s rate-setting open market committee will assess just how badly it expects to miss its dual mandate of maximum employment and stable prices.

Each FOMC member will update economic forecasts for 2011 and 2012 and make a prediction for 2013 as well. The 2013 forecasts are vital to the case for action. They are likely to show that inflation will remain below the Fed’s 2 per cent objective in three years’ time and that unemployment will still be above the rate the Fed thinks is achievable in the long run.

“Given the committee’s objectives, there would appear, all else being equal, to be a case for further action,” as Mr Bernanke put it in a recent speech in Boston.

That case is unlikely to be derailed despite opposition from some on the FOMC who feel that the risks of QE2 are too great. Thomas Hoenig, president of the Kansas City Fed, has said that looser policy is a “dangerous gamble” and is certain to vote against. Three other non-voting members are definite opponents, while several more have reservations.

Mr Bernanke is likely to carry the day, but the question is how decisive the Fed is willing to be. David Semmens, US economist at Standard Chartered in New York, speaks for many in the markets when he says: “I think a key is that the programme is aggressive and confidence inspiring.”

Rather than a huge programme of asset purchases all announced up front, the Fed has made clear that it wants QE2 to evolve in size depending on the economic data. But it is still likely to make a downpayment by pledging at least some asset purchases on Wednesday: $500bn is a likely figure for this initial round of buying.

It will also set a buying speed. The Fed already has to buy $30bn of Treasuries a month in order to reinvest early repayments from its portfolio of mortgage-backed securities, so it is unlikely to want to buy more than a further $80bn-$100bn a month. If the initial figure were $500bn, it could therefore pledge to buy them over the next two quarters. Far more important, however, is what the Fed says about further purchases once the initial round is complete. “I think what the market is looking for is a firm commitment to monetary easing going forward and without that they will be very disappointed,” said Mr Semmens.

The Fed has put intense effort into judging what it should signal and how. The FOMC has at least three broad options. First, it could be neutral, pledging to adjust the size of QE2 depending on the data. Second, it could signal a clear bias towards continuing to buy assets unless the economic data have improved. Third, it could pledge to keep buying assets until it is on track to achieve its inflation objective.

Option three is the strongest because it gives an open-ended commitment to keep expanding the size of QE2 until the economy improves. This guidance – and not the headline figure for asset purchases – is what will move markets most on Wednesday.

But there is also the chance of a surprise. Fed staff were still working on options as the committee went into “blackout” last week. On a decision this momentous, for the Fed, the US and the world economy, the meeting may take on a life of its own.

Copyright The Financial Times Limited 2010.