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The FOMC's final meeting of 2012 is just a week away (December 11-12), and the economic recovery is still not as strong as it ought to be. This continued economic weakness has caused financial journalists to speculate about the Fed increasing the size of monthly asset purchases (QE3) in 2013. This speculation was bolstered by comments from New York Fed President William Dudley, indicating that an increase in the size of QE might be necessary to offset the drag from the expiration of Twist. However, while this speculation has begun, economic growth has remained stable, and stronger than expected in the face of the looming fiscal cliff. So, what is the Fed's next police move?

Possible Stimulus Options

Aside from the obvious possibility that Fed policymakers choose to make no change to policy next week, they have several stimulative actions at their disposal.

The first and most talked about of these stimulative actions is to increase the size of asset purchases. Since Twist is expiring and the Fed will not have that capital to roll back into the market each month, their stimulus will effectively decrease from around $85 billion/month to just the measures in QE3, around $40 billion/month. The Fed could simply counteract this by increasing the quantity of monthly asset purchases and growing its balance sheet even faster.

Another idea increasingly discussed at foreign central banks is the adoption of a negative interest rate policy. The Danes have already experimented with this, but it is unlikely that the Fed will adopt such a policy without first seeing how it plays out in a much smaller economy over a prolonged period of time.

A popular idea among some academics has been the adoption of a higher inflation target. Since the 1970s, the Fed has been institutionally averse to high inflation (understandably), but this is a viable strategy that will solve some of our economic problems. However, higher inflation is certainly not a catch-all fix and as Chinn and Frieden explain, such a policy would create winners and losers.

A less bold, but similarly stimulative policy choice might be for the Fed to stimulate lending. By adopting a policy akin to the British "Funding for Lending" scheme, the Fed could work with Treasury to incentivize lenders to provide capital more readily. This would help liquidate funds on bloated balance sheets and increase the velocity of money in the market, but it does skirt a fine line between monetary and fiscal policy.

Finally, the Fed could simply change its forward guidance strategy. The FOMC has issued statements indicating that interest rates will remain low into 2014, but a number of Fed policymakers have recently come out in favor of a more concrete policy based on economic conditions. Such a policy would shift the directive to focusing on some combination of employment and inflation data, thereby running the risk that market actors assume the Fed only cares about two particular data points. However, it would likely instill confidence amongst market actors who see a data based approach as a more credible commitment than the current, date-certain approach.

Possible Headwinds

Regardless of which of these strategies the Fed ultimately adopts, the economy is still facing serious headwinds as we approach 2013. The most obvious of these headwinds is the looming uncertainty of the fiscal cliff. This uncertainty has already caused businesses to cut back on spending and alter their dividend allocation strategies to avoid future tax policy changes. If and when the cliff is averted, tax increases will inevitably be part of the deal, and this will create a sustained headwind for the recovery. However, should Congress and the President successfully agree to a long-term deal, added certainty could mitigate the damage caused by increased taxes.

In addition to much publicized concerns over the fiscal cliff, financial regulators are also weighing new rules on foreign lenders operating in the U.S. These rules could diminish available capital to U.S. borrowers and create job losses by those employed by banks operating in the U.S. that opt to leave the U.S. marketplace, rather than alter their balance sheet. Fed policymakers are well aware of this potential economic impact, but they seem to have deemed capital restrictions too important to mitigating systemic risk to allow foreign banks to operate in the U.S. without these restrictions.

Likely Policy

Given the current economic headwinds and the expiration of Twist at year-end, it is likely that the Fed will announce a modest policy change at the December (or January) meeting. It is unlikely that at this juncture a policy change will be so bold as to involve more increased asset purchases, adoption of negative interest rates or an overtly higher inflation target, but these ideas are definitely still on the table. It is more likely that the Fed will adopt a modest policy change. In my view, lending stimulus would be a preferable, modest policy option to increase the velocity of capital already sitting on corporate balance sheets. However, given that such a lending stimulus policy would likely involve a joint plan with Treasury, and the Treasury Department is busy trying to avert the fiscal cliff, such a plan seems unlikely at this juncture. So the most likely outcome (due to support from various corners of the Fed) is a change to forward guidance that involves a mix of employment and inflation targeting.

Assuming that the Fed announces this change to forward guidance next week, investors should look for debt fueled investments to jump. Increased market confidence in low interest rates should further bolster real estate assets and possibly other durable goods. Since this policy change is mostly semantic, a rally is likely to be short-lived, so investors should be ready to act ahead of time.

Source: The Fed's Next Step