The last scheduled FOMC meeting of the year will be held December 11-12.  This meeting, like all other FOMC meetings, will be closely watched since a policy change is expected.

The basis for that expectation lies in the understanding that Operation Twist, the Fed's sterilized program of selling shorter-term Treasury securities to buy longer-term Treasury securities, is due to reach its conclusion at the end of the year.

Operation Twist was implemented in September 2011 with the aim of stimulating economic activity by holding down long-term interest rates.  It was originally scheduled to end in June, but the FOMC decided at that time to extend it through the end of 2012. 

One can debate how much stimulus "Twist" has actually provided and how much of an influence it has had on long-term rates.  What is clear today, however, is that the 1.63% yield on the 10-year note is 25 bps lower than it was when Operation Twist was first announced.

The intrigue with this week's meeting revolves around the question of what the FOMC plans to do on the other side of "Twist."  That is a significant question, too, since the likely answer will involve the Federal Reserve expanding the size of its balance sheet.

To Infinity and Beyond

In September the FOMC announced a third quantitative easing program, saying it would buy additional mortgage-backed securities at a pace of $40 bln per month.  In conjunction with that plan, the FOMC said it would extend Operation Twist and maintain its policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.

The Committee said at the time that its actions would increase the Federal Reserve's holdings of longer-term securities by about $85 bln per month through the end of the year.

The real kicker, though, was that the FOMC left its quantitative easing commitment open ended. 

Specifically, the directive noted that, "If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability."

This declaration was the progenitor of the "QE Infinity" moniker that is now used by many market participants.  For our purposes today, it also serves as the basis for why we think the FOMC is going to announce the implementation of "additional asset purchases" at this week's meeting.

Warm Up the Printing Press

If the labor market outlook is the guiding principle for the FOMC's policy decisions at this point, the following factors argue in favor of additional asset purchases:

1. The unemployment rate at the time of the September meeting was 7.8%.  It is 7.7% today, so not much improvement especially when taking into account that a drop in the labor force participation rate has been a driving factor.
2. Long-term unemployed workers (27 weeks or more) account for 40.1% of the unemployed, which is unchanged from September. 
3. The fiscal cliff uncertainty has impeded hiring activity in the fourth quarter.
4. In considering the outlook, the FOMC will have to take note of the 9.1% unemployment rate projected by the CBO for 2013 in the event we go over the cliff and the 8.0% unemployment rate under the CBO's alternative fiscal scenario.
5. Recent surveys indicate small businesses are pulling back on hiring plans.
6. The midpoint of the ECB's revised GDP forecast range for 2013 shows eurozone GDP contracting 0.3%.  The weak demand in the eurozone will slow capital investment by US multinationals with exposure to the region.

Alternatively, there are two other factors that will support the decision to proceed with additional asset purchases after Operation Twist ends:

1. Inflation and inflation expectations remain in check
2. Doing nothing after the end of Operation Twist would likely be interpreted by the market as a de facto tightening of policy.  The FOMC will not want to create such an impression at this delicate juncture of fiscal cliff uncertainty.

The FOMC could step up its purchases of agency mortgage-backed securities, but our expectation is that "Twist" will be replaced with a program that targets the purchase of long-term Treasury securities so that the Fed continues to increase its holdings of long-term securities by about $85 bln each month.  The purchases will be unsterilized, which is to say the printing press will be turned back on to make them happen.

That should provide enough excitement for one directive. 

The rest of the directive should read along the same lines as the October communique, which reiterated the stance that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015 and that highly accommodative policy will remain appropriate for a considerable time after the economic recovery strengthens.

On a related note, the Federal Reserve will be updating its economic projections at the December meeting. 

In September, the central tendency for the change in real GDP in 2013 was revised up from the June projection, with the forecast range going from 2.2% to 2.8% to 2.5% to 3.0%.  With the ECB lowering its 2013 GDP forecast for the eurozone and the fiscal cliff uncertainty, we find it hard to believe that the Fed would boost its 2013 GDP growth outlook.

When Doves Cry 

Notably, the December meeting will mark the end of the voting terms for Federal Reserve Bank Presidents Lacker (Richmond), Lockhart (Atlanta), Pianalto (Cleveland) and Williams (San Francisco). 

The presidents serve a one-year term on the FOMC, with the exception of the New York Federal Reserve Bank president who has a permanent vote.  The remaining Fed presidents rotate in and out of the voting mix.  The rotation occurs in accordance with a longstanding provision that affords FOMC voting status to the seven members of the Federal Reserve Board and five of the twelve Federal Reserve Bank presidents. 

Mr. Lacker earned a reputation for being a hawk, having cast a dissenting vote at every FOMC meeting in 2012.  His dissents, however, had more to do with the Fed's communication policy than they did with the actual level of the federal funds rate, although he did stand opposed to extending "Twist" and making additional asset purchases. Ms. Pianalto and Messieurs Lockhart and Williams had more dovish dispositions.

The new voting presidents in 2013 will be James Bullard (St. Louis), Charles Evans (Chicago), Esther George (Kansas City) and Eric Rosengren (Boston). 

If Mr. Lacker was regarded as the voting standard-bearer for the hawks among Fed presidents, Mr. Evans enters the mix as the voting standard-bearer for the doves.  He will be joined by Mr. Rosengren in supporting the FOMC's very accommodative policy.  Mr. Bullard is thought of more as a centrist while Ms. George has a more hawkish mindset. 

The policy leanings of the voting presidents in 2013 can be extrapolated from some of their more recent remarks:

Dudley (New York, dove): In remarks on the national and regional economy made at Pace University, he said, "Let me reiterate that the Fed will promote maximum employment and price stability to the greatest extent our tools permit, and we will stay the course... If you're trying to get a car moving that is stuck in the mud, you don't stop pushing the moment the wheels start turning -- you keep pushing until the car is rolling and is clearly free." -- November 29, 2012

Bullard (St. Louis, centrist):  In a speech before the Little Rock Chamber of Commerce, he said, "Still, on balance I think it is reasonable to think that an outright purchase program has more impact on inflation and inflation expectations than a twist program.  Replacing the expiring twist program one-for-one with outright purchases of longer-dated Treasuries is likely a more accommodating policy.  If the goal is to keep policy on its present course, the replacement rate should be less than one-for-one." -- December 3, 2012

Evans (Chicago, dove): According to Businessweek, Evans told reporters "...that the central bank should keep interest rates near zero until unemployment falls to 6.5% or below as long as inflation is under 2.5%."  He added that, "It's important to maintain the current pace of bond purchases -- with $40 billion in mortgage-backed securities and $45 billion in longer-term government debt -- even after the expiration of Operation Twist." -- November 27, 2012

George (Kansas City, hawk): In an article published by the Daily Oklahoman, George is quoted as saying, "I was not in favor of doing more.  We have done a lot... When I look at the economy and think what it is that's holding back demand...it does not seem like these are factors conducive to more easing." -- September 19, 2012

Rosengren (Boston, dove): A Bostonherald.com article quotes Rosengren as saying, "In my view, a strong case can be made for the Federal Reserve continuing to purchase the current $85 billion in longer-term securities a month -- even after our so-called 'Operation Twist' maturity extension program is completed at the end of 2012... By altering interest rates faced by firms and households, as well as expanding the amount of reserves, the transmission of monetary policy is likely to be much more effective given that the economy has already reached the lower end for short-term interest rates." -- December 3, 2012

Overall, there shouldn't be much change in the voting complexion of the FOMC.  

Ms. George looks likely to carry the banner for the hawks and could be a dissenting voice.  Mr. Bullard will offer some balanced perspective, but is likely to side with the doves when it comes time to vote.  There is no question as to the dovish leanings of Mr. Evans and Mr. Rosengren.  Members of the Board of Governors, meanwhile, showed their allegiance to Fed Chairman Bernanke's accommodative views throughout 2012. 

What It All Means

Change happens.  It's a fact of life.

Sometimes, though, the more things change, the more they stay the same.  That should ring true for the FOMC this week with the announcement of QE4, and next year with new voters and the constancy of a dovish bias.

--Patrick J. O'Hare, Briefing.com