4 Things to Watch for From the Fed This Week

Catherine Hollander

The Federal Reserve's final policy-setting meeting of 2012 wraps up on Wednesday, capping a year where the central bank has found itself a focus of attention on Capitol Hill more than once over its efforts to boost the economy. With Washington's attention intently focused on the fiscal cliff these days, the Fed might sidestep congressional scrutiny this week. But that doesn't mean its decisions won't matter for Washington, and the rest of the country. Here are four things to watch for in the Fed's policy statement, updated economic forecasts, and the press conference with Chairman Ben Bernanke on Wednesday following the two-day meeting:

1.  Fiscal-cliff warnings. Reporters are sure to ask, and Bernanke is sure to answer: The Fed can do little to offset the economic impact of the new-year tax hikes and spending cuts that comprise the fiscal cliff if lawmakers fail to reach a deal to avert it. The Fed chief has warned lawmakers for months about the dangers of going over the cliff. “If the fiscal cliff isn’t addressed, as I’ve said, I don’t think our tools are strong enough to offset the effects of a major fiscal shock,” Bernanke told reporters at the central bank’s most recent news conference in September.

The politically independent Fed has been urging a solution to the cliff, but has steered clear of weighing in on specifics about the budget and taxes. But as the framework for a deal emerges, Bernanke may face questions about the various approaches to addressing the cliff. He will avoid taking sides. Instead, expect something more along the lines of what he said at a Senate Banking Committee hearing in July: “I think the choices between spending and taxes and the mix and the kinds of taxes and so on, I think that's really a congressional responsibility.”

2.  QE3 continues. Since the financial crisis, the Fed has launched three rounds of large-scale asset purchases, known as quantitative easing, to spur borrowing and put the economy on a path to recovery. The bank announced the latest—so-called QE3—in September. Under the open-ended program, the bank pledged to buy $40 billion worth of mortgage-backed securities each month until the labor market improves substantially.

Unemployment, which fell to 7.7 percent in November, remains well above the Fed's long-run expectations of 5.2 to 6 percent. In other words, there’s no reason to think the central bank will back off its latest QE program anytime soon. “I think absent a scenario where you get very strong job growth that brings down the unemployment rate in an appreciable and prompt way, that they are going to keep their foot on the gas pedal,” Chris Lafakis, senior economist at Moody’s Analytics, said of the FOMC.

3.  ... And may be expanded. The Fed’s $45 billion-a-month maturity-extension program, known as Operation Twist, will expire at the end of the year. For the Fed, doing the Twist means selling the short-term securities in its portfolio and using the proceeds to buy longer-term securities in an effort to bring down longer-term interest rates and spur borrowing. The bank is widely expected to replace the Twist program by expanding QE3 by the same amount of asset purchases, either in long-term Treasury securities or (less likely) mortgage-backed securities. That means the Fed’s portfolio could be growing by an additional $45 billion or so each month, or a total of around $85 billion. This is likely to raise concerns about higher inflation.

But there's another way: If the Fed wants to replace Twist but avoid making its balance sheet any larger, analysts at research firm Capital Economics pointed out in a recent research note, the bank could use large-scale reverse repos, which would "effectively sterilize" the new Treasury purchases.

4.  Hints of communications to come. The bank’s communications efforts took on added importance in December 2008, when the Fed slashed its primary policy lever—the federal-funds rate—as low as it could go. Since then, the Fed has made use of something known as “forward guidance,” giving indications of what it expects the future stance of monetary policy to be, to influence longer-term interest rates. The central bank has said that it expects to keep the federal-funds rate low through mid-2015. Members of the FOMC have been toying with the idea of tying that guidance to numerical conditions, such as the level of unemployment or inflation. But there are still concerns that the thresholds might be interpreted as an automatic trigger for raising rates. There is also the need for FOMC members to agree on what those thresholds are, and many economists expect the central bank to hold off on announcing any changes at the December meeting. But Bernanke is very likely to face a question on what’s next.

The Fed’s policy statement is expected on Wednesday at 12:30 p.m., followed by an updated summary of economic projections at 2 p.m. and a press conference with Bernanke at 2:15 p.m.