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Five questions for the Fed on the eve of QE2

By Neil Irwin

The hype and scrutiny around the Federal Reserve's policy meeting this week has been extraordinary yet justified. Eighteen Fed policymakers will gather around a giant table overlooking the National Mall on Election Day morning. By the time they are done Wednesday afternoon, they will have initiated a new wave of activism. Their likely decision: to use unconventional tools, namely buying Treasury bonds, to expand the money supply and get the economy back on track.

We have a rough sense of the contours of what the Fed will (probably) do, which I recently explored in this post. So, what are the remaining questions before the Fed is likely to announce that it will buy more government securities to try to boost the economy -- a step known as quantitative easing -- during the meeting of the Federal Open Market Committee?

1) EXACTLY HOW MUCH? As I wrote last week, Fed officials appear to have come to consensus in recent weeks on a strategy of buying hundreds of billions of dollars' worth of Treasury bonds ($500 billion is the number Fed watchers kick around most frequently). In doing so, the Fed hopes to lower interest rates on Treasurys and, in turn, on mortgage and other loans. Officials hope this would spark the consumer spending needed to help boost the economy.

That's not the gigantic $1 trillion-plus announcement that some in the financial markets are hoping for (the Fed spent $1.7 trillion buying bonds in 2009 after the financial crisis hit the year before). Nor is it an incremental approach -- for example, purchasing $100 billion a month with plans to reevaluate at every Fed meeting. The exact number officials settle on, and the pace at which they stretch those purchases out, will be the most important indicator of how aggressively the Fed will try to strengthen growth and bring inflation back toward the Fed's implicit target of 2 percent or so.

2) HOW OPEN TO EXPANSION? It's not just the volume of purchases announced that matters. More important is what the Fed statement says about how ready the central bank is to buy more securities in the future should the economy continue to underperform and inflation undershoot. The Fed will most likely indicate that it will make more purchases as necessary to try to get unemployment down and inflation in line with its target. But the subtleties of that language should be telling.

3) WHAT KIND OF INFLATION LANGUAGE? The Fed has framed the decision to buy more Treasurys as driven in significant part by the country's low inflation rate.The Fed does not have a formal inflation target set by law, as do the European Central Bank and counterparts around the world. Rather, each Fed official determines the level of inflation he or she views as consistent with their mandate from Congress to maintain price stability. Most Fed officials put that level at 2 percent. By buying bonds to try to manipulate inflation, the Fed is, in effect, acting like a central bank with a formal inflation target. The concern down the road, however, is that the new easing might push inflation past the unofficial 2 percent target -- raising prices while unemployment is still high.

4) HOW MANY DISSENTERS? There is almost certain to be one FOMC member dissenting from Wednesday's likely decision: Kansas City Fed President Thomas Hoenig. Hoenig has argued that the Fed's near-zero interest rate target and commitment to keep rates that low for an "extended period" could cause inflation and asset bubbles later on. He has voted against every Fed policy decision this year and is likely to oppose more easing measures. The question is, how many of his colleagues around the table might join him? None of the other regional Fed bank presidents whose public statements have implied opposition to new action -- Charles Plosser of Philadelphia, Jeffrey Lacker of Richmond and Richard Fisher of Dallas -- is voting this year. But keep an eye on public statements by FOMC members after the announcement. There could be more dissent on the way starting in January, when Plosser, Fisher and Minneapolis Fed President Narayana Kocherlakota, whose views on new quantitative easing have been hard to discern, all will be voting.

5) WHAT IS THE FORECAST? We won't know for certain on Wednesday. But in three weeks, the Fed will release the minutes of the meeting and its top officials' forecasts for employment, growth and inflation over the coming years. The numbers will almost certainly reflect a downgrade from the steady growth scenario the officials envisioned in forecasts released in July. At that time, they expected gross domestic product to rise in the 3.5 to 4.2 percent range in 2011 and for the unemployment rate to fall to 8.3 to 8.7 percent by the end of next year. [GDP rose at a 2 percent annual rate in the most recent quarter, and the unemployment rate was 9.6 percent in September. Neither appears poised to improve dramatically in the near future.] If the Fed revises its economic numbers for 2011, and the economy continues to underperform those projections, it's very likely the Fed will take more action on quantitative easing.

By Neil Irwin  | November 2, 2010; 8:00 AM ET
Categories:  Federal Reserve, U.S. Economy, Unemployment  
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Twas the night before QE2, when all through the house
Not a creature was stirring, not even a Wall St banker louse

The stockings were hung by the chimney with care
In hopes that Ben Shalom soon would be there

Blankfein and Dimon were nestled all snug in their beds
While visions of free money danced in their heads

Posted by: fatboysez | November 2, 2010 4:43 PM | Report abuse

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