- The Fed surprised by announcing numerical threshold values for unemployment and inflation that will guide the first Fed funds rate hike. We did expect such a move but not until spring next year.
- In addition, the expiring Twist program was fully replaced by outright treasury purchases of USD45bn per month. This means a significant expansion of the Fed's balance sheet in 2013 but this was expected.
- In terms of markets, today's decision supports the case for further steepening of the US curve going into 2013 and we continue to see value in being underweight US duration vs. EUR given the more benign US economic outlook.
The Fed delivered at the high end of expectations. The expiring Twist program was fully replaced by outright purchases of Treasury securities, which means that the Fed will buy USD 45bn in longer-term Treasury securities each month starting in January. This comes on top of the USD 40bn in MBS purchases the Fed started in September and hence the balance sheet will expand at an annual rate of USD 1,020bn, which is aggressive. The Fed will be buying in the 4-30 year segment and the duration of the purchases is a little shorter than the Twist program.
The surprise was the announcement of numerical thresholds for inflation and unemployment, which replaces the calendar guidance for the first Fed funds rate hike. The Fed funds rate is now expected to be held at its current level as long as the unemployment rate is above 6.5% and one to two year inflation expectations are not above 2.5% and longer term inflation expectations remain well anchored. However, these threshold values are not formulated as a direct rule. The statement gives the Fed some room to manoeuvre by saying that the Fed will also take other information into account such as other labour market- and inflation indicators in addition to financial developments.
According to the new projections, the unemployment rate will be in the range of 6.0-6.6% in 2015 while inflation is projected to be at 1.7-2.0%. So the new “rule” is consistent with the Fed’s previous calendar guidance that the Fed funds rate would stay unchanged until mid-2015. In that respect, the new rule should not have a great impact on market expectations for now. But once the recovery gains pace, it will be an important instrument to keep rate expectations low despite GDP growing above trend. The statement also explicitly stated that rates will remain low for a considerable time after the asset purchase program ends.
In terms of rate projections, there were only two in favour of the first rate hike in 2013 compared to three in September, three for a rate hike in 2014 compared to two in September, 13 in 2015 up from 12 and one in 2016.
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