A U.S. Fed decision to return to quantitative easing or move interest rates is highly unlikely this week, but the revolution in the way it conducts monetary policy will continue.
The Federal Open Market Committee meets on Tuesday for the last time in 2011, capping off a trying year that saw the U.S. economy sputter, forcing policy makers to take emergency action and spurring Federal Reserve chairman Ben Bernanke to take dramatic steps to demystify the institution and its policy strategy.
Over the summer, the U.S. recovery suddenly looked like it would stall. The Fed responded in September with the "Twist," Wall Street's name for an old policy trick that involves the government selling shorter-dated securities to purchase ones with longer maturities. Three of 10 votes on the FOMC opposed the policy, a rare level of dissent. Earlier this month, the Fed led a co-ordinated assault by central banks on the European debt crisis, agreeing to ensure European banks would have ready access to dollars.
But Fed officials have come to realize that pulling back the curtains might be a less controversial way of stoking economic growth than embarking on a third round of quantitative easing. With the Fed still well short of its employment goals, another asset purchase program can't be ruled out. But it seems most policy makers would prefer to try a little straight talk first.
At the previous meeting in November, Mr. Bernanke directed a subcommittee on communications to consider how the Fed might state more clearly its future intentions for policy. The directive came after what the minutes of the Nov. 1-2 meeting show was a lively discussion on the issue of transparency. After a long history of opacity, policy makers agreed last month that the time has come to open up their institution. The question that remains is how to go about doing it.
This is no trivial exercise. Academic research and the experience of central banks outside the United States suggest there is a correlation between economic growth and relative certainty about the central bank's intentions for interest rates. (This is why the Bank of Canada uses an inflation target.) And when benchmark interest rates fall to zero, as they have in the U.S., communication is even more important because businesses and executives naturally assume their borrowing costs will eventually rise. A surprise interest-rate increase is a disincentive to invest.
"The scope remains to provide additional accommodation through enhanced guidance on the path of the federal funds rate or through additional purchases of long-term financial assets," Janet Yellen, the Fed's vice-chairwoman and head of the communications subcommittee, said in a speech in San Francisco earlier this month.
A decision to return to quantitative easing is unlikely this week. Policy makers opted against doing so a month ago, and economic indicators have only improved since then. A government report earlier this month showed the U.S. unemployment rate dropped to 8.6 per cent in November from 9 per cent. Another report released last week showed the number of applications for unemployment benefits dropped by 23,000 in the week ending Dec. 3, to 381,000, the lowest since February.
"There is still a very weak employment picture; however, there have been some positive signs over the course of the fall," Philadelphia Fed president Charles Plosser said in a Dec. 2 interview on CNBC. The labour market "is certainly not falling off a cliff," he said.
Mr. Plosser is a member of the trio that opposed the Fed majority's adoption of further stimulus this fall. He and the others ended their protest in November as the policy committee opted for a wait-and-see stance. Mr. Plosser said last week that unless the European debt crisis worsened significantly, he doubted the Fed would implement new measures this week.
That puts the focus of Tuesday's meeting on the communications strategy.
The Fed likely will make significant progress, but probably will wait until January to settle on the changes. Membership of the FOMC will change in January as a new slate of regional Fed presidents rotate onto the committee and Mr. Plosser and three others rotate off. It makes sense to allow the group that will be charged with implementing the new regime to have the final say on its design. Also, the Jan. 26-27 meeting will be followed by the next of Mr. Bernanke's press conferences, which provides the chairman with an opportunity to describe fully how the new policy will work.
It's not clear yet how the Fed might adjust its communications program. At the extreme, it could follow Sweden and publish its projection for interest rates. A milder version of this approach would be revealing the range of views in the committee about future policy, much as the Fed already does with employment and inflation expectations.
The other potential option is adopting some kind of target, at least until the benchmark returns to a more typical setting. This approach has the very vocal backing of Chicago Fed president Charles Evans, who advocates setting an employment goal that the Fed would seek to achieve, provided the inflation rate stayed below 3 per cent.
Mr. Evans voted against the majority in November, saying more stimulus was needed immediately to lower the unemployment rate. If the policy committee puts off a final decision on a communications plan until January, it seems likely that Mr. Evans will do so again on Tuesday. "There is simply too much at stake for us to be excessively complacent while the economy is in such dire shape," Mr. Evans said last week.