Well, the Fed did what I expected it to do (see previous post), but it didn’t wait until after the fiscal cliff negotiations had been completed as I had hoped it would. My fear was that the politicians would take too much comfort in the Fed’s support of the economy and lose some of the needed urgency to get fiscal policy on track. The fact that the Dow lost a considerable amount of earlier gains during Chairman Bernanke’s press conference suggests that market participants didn’t think what the FOMC did today was very strong medicine.
That may have been because much of the press conference focused on the FOMC’s shift from an estimated target date, like 2015, to an economic condition, 6.5 percent unemployment, as a “guidepost” for when to consider beginning to tighten. While this was a significant change, probably for the good, I think the markets should have focused more on the other part of the FOMC’s announcement, that it would continue the bond purchase part of operation twist and discard the sales part. Specifically, they announced that they would buy about $45 billion of longer-term Treasury bonds per month in addition to the $40 billion per month of agency mortgage backed securities announced in September. By dropping the sales component of operation twist, it means that the entire $85 billion of asset purchases will add to the Fed’s balance sheet as none of it will be sterilized.
The Fed’s balance sheet had remained fairly constant at around $2.8 trillion since the end of QE2 in 2011 and had only risen to around $2.86 trillion in the two months of QE3. Now at a growth rate of $85 billion per year, the balance sheet should add another $ trillion over the next year, an increase of over one third. That is a strong new dose of stimulus that the markets apparently haven’t appreciated yet. Perhaps more of the resulting increase in bank reserves will flow through to a faster rate of growth of money, which, as a monetarist, is what I regard as the essence of monetary policy. A purely Keynesian focus on interest rates, which won’t change significantly, leads to the conclusion of more of the same. Today, at least, the markets were Keynesian.