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Fed To Continue Stimulus Amid Unstable Inflation Forecasts

 December 13, 2012 10:12 AM

(BY Mani) Expectations for continued easy policy were confirmed as it announced additional Treasury purchases, and guidelines for policy are now defined in terms of unemployment and inflation rather than time. However, the latest move comes at a time when inflation expectations are not stable.

As expected, the Federal Open Market Committee (FOMC) decided to continue with the current easing program. With its supply of short-term securities running low, the Fed will now simply buy long-term Treasury securities of about $45 billion per month. This should increase the Fed's balance sheet and thereby supply greater liquidity to capital markets.

The Committee's outlook for real GDP growth in 2013 is 2.3-3.0 percent, which is slightly more pessimistic than the September forecast.

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"To us, it appears that the FOMC's expectations do not include a significant hit to consumer spending in 2013 from the expiration of the payroll tax and extended unemployment benefits, nor to business spending due to the end of bonus depreciation, which are essential elements of our forecast," Wells Fargo economist John Silvia wrote in a note to clients.

There is also the risk of a weak compromise on the fiscal cliff that does little to alter the long-term budget issues.

The Committee specified its interest rate guidance, with the target rate to remain exceptionally low "at least as long as the unemployment rate remains above 6.5 percent [and] inflation between one and two years ahead is projected to be no more than a half percentage point above the committee's 2 percent goal."

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"The moderate pace of growth that we expect would be consistent with only a modest decline in the unemployment rate, and this is consistent with the FOMC's projections of the jobless rates of 7.4-7.7 percent by the end of 2013," Silvia said.

Meanwhile, the longer-run unemployment rate range was unchanged at 5.2-6.0 percent.

Over the past two years, the decline in the unemployment rate has reflected an improved job market but also the impact of changing demographics and some disincentives to work/hire due to tax and regulatory changes that have developed in recent years. Therefore, due to structural change, it is difficult to see to what extent policy has positively influenced job gains.

As evidenced by the gradual rise in the 5-year, and 5-year forward TIPS (Treasury Inflation-Protected Securities), inflation expectations measure, long-term inflation expectations have risen and have not been stable as asserted in the FOMC statement.

With 5-year inflation expectations at 2.06 percent, the real yields on savings and Treasury instruments with maturity below five years are negative. For some time, the pricing of Treasury instruments has been skewed by foreign government purchases while the Fed has been increasing its balance sheet.

"These buyers are not mark-to-market buyers, and therefore, it becomes increasingly difficult for private actors to price non-Treasury financial assets since the risk-free benchmark rate is not reflective of traditional free-market forces," Silvia added.

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