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duration of their securities portfolio through operationtwist.Operation twist was recognised in the minutes fromSeptember FOMC meeting as being “necessarilylimited by the amount of shorter-term securities in theSOMA portfolio” and “a number of participants sawlarge-scale asset purchases as potentially a morepotent tool that should be retained as an option in theevent that further policy action to support a strongereconomy was warranted”.A number of Fed speakers including Chicago FedPresident Evans, Boston Fed President Rosengren,New York Fed President Dudley, Governor Tarullo,Vice Chair Yellen, and Chairman Bernanke himselfhave all confirmed that QE3 is very much still anoption they are willing to turn to. This puts to rest thenotion that the Fed is being held back by a potentialpolitical backlash domestically and abroad. Many ofthese speakers have specifically emphasised theindependent nature of the Fed.In the meantime, the September minutes alsoindicated that “most participants indicated that theyfavoured taking steps to increase further thetransparency of monetary policy”. Indeed “mostparticipants also indicated they saw advantages inbeing more transparent about the conditionality in theCommittee’s forward guidance by providing moreinformation about the economic conditions to whichthe guidance refers”.Last week, Chicago Fed President Evans proposed apolicy rule in which the Fed “commit[ed] to keepshort-term rates at zero until either theunemployment rate goes below 7 percent or theoutlook for inflation over the medium term goesabove 3 percent”, Without endorsing the specificrule, Vice Chair Yellen referred to President Evans’proposal as “potentially promising” as it would“facilitat[e] public understanding of how various shiftsin the economic outlook would be likely to affect theanticipated timing of future policy”.Chairman Bernanke recently gave a speechdescribing the global paradigm of monetary policy as“flexible inflation targeting” or “constraineddiscretion.” This is a policy characterised by explicitguidance on long-term inflation goals combined withnear-term flexibility to deviate from these targets and“respond to economic shocks as needed to moderatedeviations of output from its potential”. However, healso noted that, in contrast to many central banks,the Fed has a dual mandate for “maximumemployment and price stability, on an equal footing”.Thus, it would appear that the Chairman issympathetic to providing more explicit guidance onthe longer-term goals for both inflation andunemployment. Indeed, the September FOMCminutes highlighted that the Committee would like tocouch its current policy in the context of mediumtermgoals for employment and inflation while, at thesame time, confirming its commitment to longer termgoals. The minutes noted that this was a complicatedtask and that the post-meeting statement as “not wellsuited to communicate fully the Committee’s thinkingabout its objectives and its policy framework”. TheNovember meeting with its forecast and postmeetingpress conference is, therefore, ideally suitedto roll out such a new policy framework.There are a number of ways the FOMC couldprovide more concrete medium-term markers for itspolicy. It could maintain the time commitment put inplace in August but be clear about the conditionsthey expect to prevail at that time. Marketparticipants could then adjust their expectationsaccording to their own forecasts and changes ineconomic conditions. Alternatively, they could go theroute suggested by President Evans in which theyeschew the time frame altogether and make thecurrent policy stance explicitly contingent oneconomic conditions. Even their prior forecasts forthe unemployment rate suggest that a policytightening would not be likely before “at least throughmid-2013” and very likely after that under newforecasts. Therefore, the new communication policywill also be a policy easing as it will push rate hikeexpectations back even further.The new framework will also provide guidance aboutwhat the triggers for further easing will be. Consistentwith prior communication, we think that the triggerwould be failure to make progress on their mandates.That is, if inflation decelerates and unemploymentfails to decline, the Fed would be ready to expand itsbalance sheet. In particular, recent Fedspeak hasindicated a shift toward a renewed focus onmortgage purchases along with Treasury purchases.Such a policy has the advantage of targeting themost distressed sector of the economy, and it alsohelps accommodate some of the blow to mortgagemarkets of recent mortgage refinancing proposalsthat will inflict losses on mortgage investors. Weexpect QE3 as early as December just as themortgage refinancing program is kicking into gear.If at first you don’t succeed…While it may have appeared in recent months thatthe Fed was becoming less aggressive, it nowappears that they were simply stepping back andreformulating their reaction function. As PresidentEvans acknowledged “more than once the FOMC’sprojections have proved too optimistic, and the U.S.economy has been unable to achieve escapevelocity for returning to stronger, self-sustaininggrowth. But instead of doing nothing, the FOMC tookJulia Coronado 27 October 2011Market Mover6www.GlobalMarkets.bnpparibas.com