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Economic Update


October 24, 2012

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To no one's surprise, the Federal Open Market Committee (FOMC) concluded its October meeting this afternoon without changing course. The quantitative easing program initiated in September (QE III) will continue, and the promise to hold short-term rates near zero until 2015 remains in place. Once again, Richmond Fed President Lacker cast the only dissenting vote.

Today’s policy statement contained small modifications to the September Fed dispatch. Consistent with the latest readings on consumer spending ("Household spending has advanced a bit more quickly") and housing ("The housing sector has shown further signs of improvement…"), the Fed views these components of spending in a more positive light compared with the assessment at the September FOMC meeting.

Despite the decline in the unemployment rate for September (7.8% vs. 8.1%), the Fed maintained its view of worrisome labor market conditions. The Fed pointed out that inflation has "picked up somewhat" as a result of higher energy prices. Energy prices have lost ground in recent days reflecting the possibility of soft global economic activity.

The market is still awaiting additional clarity on what sort of labor market improvement would be sufficient to curtail QE III. That topic was to be discussed further at this FOMC meeting, but we likely won’t know the content of those discussions until the minutes are released three weeks from now.

The next big decision point for the FOMC is whether to continue purchasing Treasury securities at the conclusion of "Operation Twist." As bonds purchased by the Fed march toward maturity, Operation Twist has reinvested them to keep downward pressure on long-term interest rates. This activity has amounted to about $45 billion each month, larger than QE III. We expect the program will be extended beyond its scheduled year-end expiration.

As we near the election, there has been a lot of discussion of how the outcome might impact the Federal Reserve. While the Fed is independent of Federal policy makers, members of the Board are nominated by the President and confirmed in Congress. As shown below, several terms on the Federal Reserve Board will expire within the first year of the new Administration:

Member Term Expiration
Ben Bernanke (Chair) Chairman's Term 1/2014, Full Term 2020
Janet Yellen (Vice Chair) Vice Chairman's Term 10/2014, Full Term 2024
Elizabeth Duke January 2012 (already expired)
Daniel Tarullo 2022
Sarah Bloom Raskin 2016
Jeremy Stein 2018
Jerome Powell January 2014

The lion's share of speculation has focused on the future of Ben Bernanke. In August, Governor Romney stated that, if elected, he would not re-appoint the Chairman. President Obama has been silent on this subject.

Focusing on the next President's choice overlooks a critical question: does Chairman Bernanke want to stay? By all accounts, it has been a long six years at the helm. The financial crisis prompted the Fed to move into new territory with its monetary policy and with its supervision of financial institutions. Both migrations have invited a great deal of political commentary, and Bernanke has endured rounds of criticism that would have been unthinkable a decade ago. A retreat to academe, and publishing, might be tempting.

On the other hand, reports suggest that the Chairman would like to see the Fed’s recent efforts through to a successful conclusion, which would include a smooth exit from all of the quantitative easing done over the past several years.

A factor which might bear on the decision is the degree to which Chairman Bernanke's hold on the FOMC will remain firm. The normal rotation of voting members will see the following transitions in 2013:

Departing Entering
Jeffrey Lacker (Richmond) Charles Evans (Chicago)
Dennis Lockhart (Atlanta) Eric Rosengren (Boston)
Sandra Pianalto (Cleveland) James Bullard (St. Louis)
John Williams (San Francisco) Esther George (Kansas City)

While it is difficult to draw bright lines between monetary philosophies, it appears on the surface that the mix of "hawks" (who might favor tighter policy to control inflation) and "doves" (who might favor easier policy to promote maximum sustainable employment) will not change that much in the new year. Chairman Bernanke should therefore be able to sustain the broad consensus which has supported recent actions.

Should Bernanke opt to depart, his replacement would have big shoes to fill. If the President is re-elected, speculation has centered on the elevation of Janet Yellen to the chair. A Republican administration might consider Glenn Hubbard or Greg Mankiw, prominent economists who served George W. Bush and who are currently advising Governor Romney.

Markets will certainly be watching these transitions very closely. Attention will be focused on the backgrounds of any new players and any signs that the Fed's traditional independence might be compromised. That independence has worked to the benefit of our economy over the past generation, and should be defended.
The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.