What to expect from the FOMC tomorrow

There has been some confusion about the potential policy actions the Fed could undertake at the next meeting. This is what we could expect from the FOMC tomorrow as well as the corresponding market reactions:

• It is highly likely the committee will announce an easing action of some sort.
• The policy decision will probably involve extended guidance, projecting fed funds rate to be near zero for longer than in previous guidance announcements. Once again, this is not a commitment, only guidance.
• The Fed will also likely announce some form of a securities purchase program. The purchases would take one of the three forms:

1. Extension of Operation Twist. This is the easiest form of policy change for the Fed to implement since the program is already in place. The problem is that the Fed has only some $175bn of short tenor securities to sell (in order to buy the same amount of longer tenor bonds), which would take it to September. That may be enough however as the FOMC agrees to revisit the situation then ("kick the can" policy).

       Market reaction: If this were the only policy move, risk assets would sell off.

2. Sterilized purchases. The Fed would use 1-4 week reverse repo to avoid increasing bank excess reserves (avoid "printing money") . An alternative or a complement to using reverse repo is for the Fed to accept term deposits which would also reduce reserves. The one criticism of this program is that it could put upward pressure on 1-4 week rates because the Fed would be constantly in the market borrowing short term money. But this is generally viewed as an acceptable risk.

As discussed before, this program is likely to involve MBS purchases for a couple of reasons. MBS yields have a bit more room for compression than treasuries do. Also focusing on "helping" the housing market would be politically more palatable for the Fed than being seen as funding the federal budget deficit.

      Market reaction: Depends on the size. $400-$600bn would be a positive for risk assets

3. Unsterilized (outright) securities purchases, otherwise known as Quantitative Easing (QE3). Securities purchases would be funded by increasing the bank excess reserves ("money printing"). As discussed before, this scenario is unlikely because it would be kept as a "weapon of last resort". It would be employed in an absolute crisis situation, such as a major sovereign default in the Eurozone or an Iran induced global oil disruption. QE is also highly unpopular and the Fed is not impervious to popular opinion. Given the current expansion of credit in the US, QE would be difficult to justify.

     Market reaction: Risk assets would rally (obviously depending on what else is going on globally)

All of these programs will have only a limited effect on the US economy. Even MBS purchases, the best option out there, are not expected to yield tremendous results in generating growth and jobs. A 30-year mortgage at 2% will put some cash in people's pockets for those who can refinance. But it's not going to improve the credit score for those who can not refinance or do not qualify for a mortgage. And the 10-year treasury at half its current yield (which is what Japan has) is hardly going to help improve economic activity. But the Fed promised to stay vigilant, and given the limited toolbox, these policy moves may be the best the central bank will be able to accomplish on its own.

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