Fed to twist again?

Fed chairman Bernanke’s congressional testimony today offered no real surprises, leaving the door open for more policy easing in the event that “financial stresses escalate”.

He offered few hints that further monetary stimulus is imminent and unlike recent comments from vice chairman Yellen and New York Fed president Dudley, his comments did not include a list of possible easing options. However, Bernanke did emphasise that the Fed’s conditional commitment to keeping rates exceptionally low until at least late 2014 as well as its Operation Twist have supported the economic recovery by putting downward pressure on longer-term interest rates, including mortgage rates, and by making broader financial conditions more accommodative.

I interpret this as implying that the Fed is leaning more towards an extension of Operation Twist rather than pure QE at the 19-20 June FOMC meeting.

Extending Operation Twist beyond its scheduled conclusion at the end of this month is possible for at least three more months as the Fed has enough short-dated Treasury holdings it can sell against purchasing long-term debt. Such an extension would be an insurance policy against the risk of further downside surprises and would enable the Fed to evaluate the situation and launch QE3 later in the summer if things deteriorate further.

This will obviously partly depend on how the situation in Europe develops. A Greek exit from the euro would undoubtedly prompt an immediate and powerful response from the Fed, likely in a coordinated action with other major central banks.

Moreover, Bernanke urged Congress to avoid any massive fiscal tightening at the start of next year while, at the same time, to take action to put the budget on a long-term sustainable path. I do hope they are listening. Failure to do so would have negative effects on the economy that even the Fed couldn’t offset.

Overall, I continue to expect the Fed to announce another easing step on 20 June. At this point, an extension of Operation Twist seems more likely than a broader purchase programme involving mortgage-backed securities and long-term Treasuries securities (pure QE3).

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