In the last FOMC meeting held in June, the Fed announced an extension of “Operation Twist” by $267 billion. The idea is to sell short term bonds and buy long term ones, thus lowering long term yields and encouraging investment.
There is lots of room to doubt if this is effective: low borrowing costs aren’t really encouraging banks to lend and aren’t boosting the economy. Long term yields are already very low, and there’s not much room left on the downside.
Nevertheless, the Fed gets to show it is doing something without changing the size of its balance sheet, thus not printing more dollars. Some analysts saw it as a stepping stone towards the real thing: QE3 – a further expansion of the balance sheet that will devalue the dollar and start a stock market rally.
However, this seems more like a substitute to QE3, and we can expect another disappointment. At the end of July, the Federal Reserve will begin its two day meeting, with the result of this meeting announced on August 1st.
So why will the Fed refrain from action?
- The Fed doesn’t make changes too often: most meetings end in reiterating the previous statement with a small change of tone about the economy. After the recent decision to extend Operation Twist, the chances are high that no action will be taken.
- Diminishing Returns: The Fed’s non-conventional programs are of a diminishing scale: QE1 was huge, QE2 was significant, Operation Twist 1 was already smaller and OT2 was even smaller. Also the effect of more QE has “diminishing returns” according to Bernanke. As aforementioned, yields are already so low, that the diminishing returns are easy to see.
- Housing is climbing: Housing is one of the concerns on the Fed’s agenda. With a rise in prices and in activity, there is no reason to act (see details above).
- Deflation is not a threat: The goal of QE2 was to avert deflation – a situation where prices fall, consumers are discouraged to buy, they further fall, etc. While prices rises are more moderate than earlier, and this was noted by some Fed members, the US is still too far from deflation.
- Politics: Three months before the US elections, every move by the Fed will be closely watched. Republicans have criticized the Fed too often for the QE programs. Bernanke will not hesitate to act if a huge disaster appears, but unless there’s a wholesale collapse, he has no reason to grab attention.
It’s hard to see any change coming from the Fed at this time. Even if the initial estimation for Q2 GDP is terrible, the Fed will likely wait. Also the conditional pledge to leave interest rates unchanged until late 2014 will likely remain unchanged. It’s just too far off in the future.
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