The Fed has extended Operation Twist through year end. But this will be the last Twist. Thereafter, if the economy deteriorates further, the Fed will need to employ additional non-standard tools to stay relevant for financial markets.
I n the press conference yesterday, Fed Chairman Bernanke said that the Operation Twist announced would be the last of its kind and implied that the next step would be further quantitative easing – if warranted.
Indeed, the official release highlighted that the Fed is more cautious on the growth outlook, that inflation has eased and that it is “prepared to take further action as appropriate”. This new phrasing suggests policymakers are leaning heavily toward more action if the labor market does not soon improve.
The Fed does not (yet) target a specific unemployment rate, but does target a core inflation rate. Policymakers revised up their forecast for the Q4 2012 unemployment rate to 8-8.2% (previously 7.8-8%) and revised down their official Q4 2012 inflation projections to 1.7-2% (the target is 2%).
We have highlighted in the past that announcements of QE2 and Operation Twist both coincided with a drop in TIPS breakeven inflation rates at the long end of the curve to roughly 2.0%. These levels have not yet been breached, and probably was a significant reason why the Fed stopped short of QE3 at yesterday’s meeting.
Also important is that Chairman Bernanke was supportive of the Bank of England’s proposed “funding for lending” scheme and hinted that it is a possible course of action for the Fed, should economic conditions deteriorate.
Bottom line: The Fed is sending a clear message that policymakers are willing to act with credible force, which should be a near-term positive for risk assets.