LITTLE ROCK - If Federal Reserve policymakers are going to replace the expiring "Operation Twist" purchases of long-term Treasury securities with outright Treasury purchases, and if they want to keep the current level of monetary stimulus, then they should do so on a less than one-for-one basis, St. Louis Federal Reserve Bank President James Bullard said Monday.
Otherwise, the Fed's policymaking Federal Open Market Committee will be making monetary policy even more accommodative than it already is, because outright Treasury purchases would be "more potent" than Twist purchases.
Bullard, who will be a voting member of the FOMC next year, also appeared to move closer to endorsing a 6-1/2% threshold for raising the federal funds rate. But he warned that while the present use of a calendar date to signal the start of rate hikes has problems, economic thresholds pose "six distinct challenges."
If the FOMC is going to describe a set of economic conditions or thresholds it must take great care in how it proceeds and be aware that financial markets will see thresholds as "triggers for action."
At their Dec. 11-12 FOMC meeting, Fed policymakers will be deciding how much and what type of assets to purchase in 2013. The Fed's Maturity Extension Program, better known as "Operation Twist," under which the Fed has been selling $45 billion a month of short-term Treasury securities and buying an equal amount of long-term Treasuries, expires Dec. 31.
If nothing is done by the FOMC, aggregate Fed asset purchases will shrink from a month from $85 billion currently to $40 billion, the amount of mortgage-backed securities the Fed is buying under the third round of "quantitative easing."
MNI reported last week that there is "substantial sentiment" on the FOMC for fully replacing the expiring Twist purchases with outright purchases, effectively expanding QE3 to $85 billion. Unlike Twist purchases, outright purchases would be financed by the creation of new money or bank reserves.
Earlier Monday, Boston Fed President Eric Rosengren, who also will be voting next year, said he favors a continuation of $85 billion of asset purchases next year and suggested the Fed should increase the proportion of MBS purchases.
Bullard did not address the issue of whether MBS would be better than Treasury purchases, but by implication suggested that he would prefer the latter.
"Operation Twist can be replaced with outright purchases of Treasury securities," he said in remarks prepared for delivery to the Little Rock Chamber of Commerce. "This is an advantage of the 'state contingent' approach to the balance sheet policy adopted in September."
But "outright purchases are likely more potent than twist operations," Bullard said. "This suggests somewhat less than one-for-one replacement if the Committee's intent is to keep policy unchanged."
"I interpret a one-for-one replacement of twist operations with outright purchases as more accommodating than the current policy," he said, adding, "outright purchases of longer-dated Treasuries with newly created reserves eliminates the sale of short-term securities and so may be viewed as somewhat more stimulative."
"(O)n 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," he said. And so "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," he added.
Bullard, who has never been comfortable with the use of a calendar date to signal how long the Fed intends to keep the federal funds rate near zero, said the FOMC's current stance of saying it expects to keep the funds rate at that level "through at least mid-2015" sends "an unwarranted pessimistic signal."
"The date can be interpreted as a statement that the U.S. economy is likely to perform poorly until that time," he said.
Bullard said using a calendar date is also problematic because the FOMC "has been reluctant to change the date unless the change in the outlook has been substantial. This means that markets at times have a somewhat different date in mind than in the Committee statement."
Without giving a timeframe, Bullard said the FOMC "may wish to eliminate the date in the statement in favor of a description of economic conditions at the time of the first rate increase. Then, as data arrive on U.S. economic performance, private sector expectations concerning the timing of the first rate increase would automatically adjust."
Chicago Fed President Charles Evans last week proposed that the FOMC keep the funds rate at zero so long as unemployment remains 6.5% or higher and inflation is 2.5% or less. He had previously favored a 7/3 threshold.
Bullard lent some support to the Evans proposal, saying "the 6.5 value for the unemployment rate is broadly consistent with mainstream analysis of the likely value of the unemployment rate at the time of the first increase in the =policy rate. Likewise, many expect inflation to remain low."
Echoing Fed Vice Chair Janet Yellen, Bullard said such a threshold system would act as "an automatic stabilizer."
But Bullard issued a number of caveats.
"Care needs to be taken that this does not represent a return to 1960s-style macroeconomics, in which many thought unemployment could be meaningfully targeted by the central bank," he said. "That approach to policy was badly discredited in the 1970s."
Besides, he noted that the FOMC's January 2012 statement on long-term goals and strategy "makes it clear that the FOMC cannot meaningfully target unemployment."
If the FOMC does adopt thresholds in place of a calendar date, it should use "actual values" for unemployment and inflation, not forecasts, as some threshold advocates have proposed, Bullard said.
But he said "care should be taken that the Committee does not leave the impression that only these two variables matter for monetary policy. That would greatly oversimplify any reasonable judgment concerning the state of the U.S. economy."
Bullard said the FOMC should stress that it will be looking at other labor market indicators besides the unemployment rate, such as payrolls, labor force participation and hours worked.
And he said the FOMC "needs to emphasize that unemployment can remain elevated for reasons unrelated to monetary policy."
Bullard cited the experience of Europe, where high structural unemployment has proven impervious to monetary easing.
"An unemployment threshold of 6.5% would never have been breached in the euro zone over the last 20 years," he said. "Despite this, the ECB did raise the policy rate at times during this period and did keep the Euro-area inflation rate near 2%."
Bullard said the FOMC must also "recognize that thresholds will likely be treated as 'triggers for action' in financial markets.
"In essence, the effect of a threshold announcement is to draw a line in the sand," he said. "Crossing the threshold means something significant has occurred."
"Even if policy action is not required right at that moment, the probability of action is increased," he continued. "Markets will react to the probability of policy action."
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