FOMC Meeting: What the Fed Policy Changes Mean For You

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The Federal Open Market Committee (FOMC) meeting ended yesterday (Wednesday) with two important changes to Fed monetary policy.

First, the central bank said it would increase the amount of quantitative easing by replacing Operation Twist, which ends Dec. 31, with outright purchases of long-dated Treasury bonds.

Under Operation Twist, every month the Fed sold $45 billion in short-term Treasury bonds and notes and bought $45 billion of long-term Treasury bonds in an effort to keep long-term interest rates low.

Because the Fed funded its purchase of long-term bonds with the sale of short-term bonds and notes, no new money was created.

However, outright purchases of long-term bonds will create new money-$45 billion every month-and, by concentrating its buying at the long end of the yield curve, the Fed should be able to keep long-term interest rates low.

The Fed also said it will continue to purchase $40 billion of mortgage-backed securities each month, creating a total of $85 billion in new money from these operations monthly.

That means QE4 is here.

Starting in January, the Fed will be more than doubling the amount of money it is pumping into the economy. Happy New Year!

Second, the Fed set unemployment and inflation "thresholds," instead of setting a date for when the central bank expects to be able to raise interest rates. What this means is that the Fed will not raise interest rates unless unemployment is 6.5% or less or inflation is more than 2.5%.

By setting thresholds where monetary policy might change, the Fed is attempting to improve its communications with the public.

After the FOMC: Addressing the Fed's "Pessimism Problem"

This might not seem obvious, so let's explain.

A Dec. 3, 2012 presentation by St. Louis Federal Reserve Bank President and CEO James Bullard addressed this issue.

Until yesterday, the FOMC had said, "the policy rate will likely remain near zero until mid-2015.'"

Bullard says that this created a "pessimism problem" for the Fed.

"The date can be interpreted as a statement that the U.S. economy is likely to perform poorly until that time... The committee does not intend to send such a signal."

In yesterday's statement, the FOMC decided that zero interest rates "will be appropriate at least as long as the unemployment rate remains above 6.5%, inflation between one and two years ahead is projected to be no more than [2.5%]."

The FOMC said it will consider a wide range of indicators besides the unemployment rate and the outlook for inflation.

"When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent," yesterday's statement read.

The New Fed Policy: More Transparent

"This approach is superior" to setting a timetable for a possible rate increase, Fed Chairman Ben Bernanke said at a news conference yesterday.

"It is more transparent and will allow the markets to respond quickly and promptly to changes" in the Fed's economic outlook.

In other words, when you see that unemployment is falling to 6.5% or below and inflation as measured by the consumer price index is running at more than 2.5%, there is a greater chance that the Fed will raise interest rates.

By making the decision to end the zero interest rate policy dependent upon economic data, the Fed gains flexibility and loses its "pessimism problem." Markets would "automatically adjust" to the timing of the first interest rate hike based on the latest economic data.

"If information comes in which says the economy is stronger or weaker than we expected, that would in principle require a change in the date, but it doesn't necessarily require a change in the thresholds, because that data adjustment can be made by markets just simply by looking at their own forecasts," Bernanke said at yesterday's press conference.

For investors, being able to use widely followed, publicly available information to assess the timing of the end of the zero interest rate policy makes the decision-making process at the Fed more transparent.

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