- We expect the Fed to replace the expiring Twist programme with outright Treasury purchases, thereby adding another monetary boost to the economy from January.
- It is too early for the Fed to announce a new framework of numerical thresholds for inflation and unemployment. More time is needed to reach consensus.
Although the labour market has improved in recent months, the unemployment rate is still far from being within the Fed’s comfort zone and the economic recovery remains fragile. In addition, inflation pressures seem to be non-existent with wage inflation close to 1% y/y and core PCE well below the Fed’s comfort zone.
Fiscal policy looks set to remain a drag on growth next year and 2014 and we think the Fed will not risk derailing the fragile improvement with a premature removal of stimulus. Hence, we expect the Fed to provide an additional monetary boost to the economy next year by replacing the Twist programme with unsterilised Treasury purchases.
The question is whether the Fed will scale down from the USD 45bn per month in the current Twist programme. As highlighted by St Louis Fed President Bullard last week, the stimulative effect from outright purchases is higher than the Twist programme, which sterilises the longer-term purchases by selling an equal amount of shorter dated papers. According to Bullard, the Fed could go down to USD 25bn and still have the same impact on the economy.
Although a scale-down is possible, the easiest way forward is to buy the full USD 45bn. A smaller amount could be taken as a signal that the Fed is scaling down its asset purchases and actually send short interest rates higher. We expect the additional Treasury purchases to be in the range of USD 30-45bn and the most likely outcome is the full USD 45bn. This will mean more than a doubling of the current pace of balance sheet expansion, taking the annual pace to just above 1,000bn. Hence the economy will receive another monetary boost starting in January next year.
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