March 13, 2012 1 of 213 Meeting of the Federal Open Market Committee on March 13, 2012 A meeting of the Federal Open Market Committee was held in the offices of the Board of Governors of the Federal Reserve System in Washington, D.C., on Tuesday, March 13, 2012, at 8:30 a.m. Those present were the following: Ben Bernanke, Chairman William C. Dudley, Vice Chairman Elizabeth Duke Jeffrey M. Lacker Dennis P. Lockhart Sandra Pianalto Sarah Bloom Raskin Daniel K. Tarullo John C. Williams Janet L. Yellen James Bullard, Christine Cumming, Charles L. Evans, Esther L. George, and Eric Rosengren, Alternate Members of the Federal Open Market Committee Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser, Presidents of the Federal Reserve Banks of Dallas, Minneapolis, and Philadelphia, respectively William B. English, Secretary and Economist Deborah J. Danker, Deputy Secretary Matthew M. Luecke, Assistant Secretary David W. Skidmore, Assistant Secretary Michelle A. Smith, Assistant Secretary Scott G. Alvarez, General Counsel Thomas C. Baxter, Deputy General Counsel Steven B. Kamin, Economist David W. Wilcox, Economist David Altig, Thomas A. Connors, Michael P. Leahy, David Reifschneider, Glenn D. Rudebusch, William Wascher, and John A. Weinberg, Associate Economists Brian Sack, Manager, System Open Market Account Michael S. Gibson, Director, Division of Banking Supervision and Regulation, Board of Governors Nellie Liang, Director, Office of Financial Stability Policy and Research, Board of Governors March 13, 2012 2 of 213 Jon W. Faust and Andrew T. Levin, Special Advisors to the Board, Office of Board Members, Board of Governors James A. Clouse, Deputy Director, Division of Monetary Affairs, Board of Governors Linda Robertson, Assistant to the Board, Office of Board Members, Board of Governors Seth B. Carpenter, Senior Associate Director, Division of Monetary Affairs, Board of Governors Thomas Laubach, Senior Adviser, Division of Research and Statistics, Board of Governors; Ellen E. Meade, Stephen A. Meyer, and Joyce K. Zickler, Senior Advisers, Division of Monetary Affairs, Board of Governors Eric M. Engen, Michael T. Kiley, and Michael G. Palumbo, Associate Directors, Division of Research and Statistics, Board of Governors Edward Nelson, Section Chief, Division of Monetary Affairs, Board of Governors Harvey Rosenblum and Daniel G. Sullivan, Executive Vice Presidents, Federal Reserve Banks of Dallas and Chicago, respectively Craig S. Hakkio, Geoffrey Tootell, and Kei-Mu Yi, Senior Vice Presidents, Federal Reserve Banks of Kansas City, Boston, and Minneapolis, respectively Michael Dotsey, Joseph G. Haubrich, Lorie K. Logan, and David C. Wheelock, Vice Presidents, Federal Reserve Banks of Philadelphia, Cleveland, New York, and St. Louis, respectively Marc Giannoni, Senior Economist, Federal Reserve Bank of New York March 13, 2012 3 of 213 Transcript of the Federal Open Market Committee Meeting on March 13, 2012 CHAIRMAN BERNANKE. Good morning, and let me turn to Brian Sack for the presentation. MR. SACK.1 Thank you, Mr. Chairman. Investors continued to become more optimistic about the economic outlook and less concerned about the risks associated with the European situation, leading to sizable gains in risky asset prices over the intermeeting period. This optimism was driven in part by the incoming economic data, which were somewhat stronger than investors had expected. In addition, investors grew increasingly confident that a disorderly outcome from the European bank and sovereign debt problems would be avoided due to the aggressive liquidity policies of the ECB and the completion of the debt exchange in Greece. In response to these developments, equity prices increased notably since the last FOMC meeting, with the S&P 500 index advancing more than 4 percent, as shown in the upper-left panel of your first exhibit. Other risky assets also performed strongly, with yield spreads on corporate bonds and some structured credit products narrowing. Despite this shift in sentiment toward riskier assets, the 10-year Treasury yield was little changed over the intermeeting period, as can be seen in the chart. In fact, the 10-year yield has held relatively steady since last fall, even though the S&P index has risen about 15 percent over that period. The low level of yields reflects that investors expect monetary policy to remain accommodative for a long period and see some chance that the FOMC could take additional policy actions. Over the current intermeeting period, the most important development in this regard was the strengthening of the forward guidance about the federal funds rate in the January FOMC statement. Many investors had been expecting a change to this guidance, but the extension to “at least through late 2014” went beyond those expectations. In response, as shown to the right, primary dealers pushed back the expected timing of the first increase in the federal funds target rate, with the highest probability now placed on it occurring in the second half of 2014. Consistent with this shift, market-implied expectations for the federal funds rate beyond mid-2014 shifted down slightly over the intermeeting period. Market participants generally understand that the policy guidance is not an absolute commitment, but instead is tied to the evolution of economic conditions. To get a sense of how this conditionality is viewed, the dealer survey asked for the combinations of the unemployment rate and inflation rate that would prompt the first increase in the federal funds target rate. The results, shown in the middle-left panel, indicate that respondents see the type of tradeoff between these variables that would be present under a Taylor-type policy rule, with the FOMC expected to wait for lower 1 The materials used by Mr. Sack are appended to this transcript (appendix 1). March 13, 2012 4 of 213 levels of the unemployment rate if inflation were running lower. The median response from the survey has the first increase in the federal funds target rate occurring with the unemployment rate around 7 percent and the inflation rate around 2 percent. The chart also shows that this schedule has moved lower since last September, when the Desk first asked this question. This shift suggests that the change in the forward guidance caused market participants to reevaluate their assessment of the Committee’s policy reaction function, with the FOMC now expected to wait for a lower level of the unemployment rate for a given level of inflation compared with the September survey. Even though the commitment is viewed as conditional, the policy guidance had a meaningful effect on the amount of uncertainty perceived around the path of interest rates. As shown to the right, the implied volatility of short-term interest rates three years ahead—the horizon roughly consistent with the “late 2014” guidance at the time of the FOMC statement—moved down on the announcement, as investors saw higher chances that short-term interest rates would remain unchanged. It has since moved higher, presumably because the incoming data have raised the probability that economic conditions would warrant an earlier liftoff, although it remains very low by historical standards. The prospect that the federal funds rate could remain at its current levels through late 2014 is clearly helping to hold down Treasury yields. In addition, the balance sheet policies implemented by the FOMC are also playing a role by keeping the term premium very low. As shown in the bottom-left panel, the 10-year term premium measured by the Kim–Wright model stands at minus 50 basis points, which is about 125 basis points below its average level since the late 1990s. Analysis by the Board staff suggests that the FOMC’s balance sheet actions have kept this term premium about 60 basis points lower than it would otherwise be, explaining about half of the deviation from its longer-run average. Of course, that estimate implies that the term premium would still be unusually low even in the absence of the FOMC’s balance sheet actions. These patterns suggest that there is some risk that yields could move up meaningfully at some point, particularly as investors come to see the balance sheet as a less active policy instrument or anticipate a return of more-normal interest rate uncertainty. Perhaps reflecting such risk, the premium on options that provide protection against a rise in interest rates has been increasing in recent months. The panel to the right focuses on the inflation prospects priced into the Treasury market. As can be seen, the five-year breakeven inflation rate has moved higher, driven by increases in energy prices and greater optimism about the growth outlook. However, the five-year, five-year-forward measure edged down, as longer-term inflation expectations remain well contained. March 13, 2012 5 of 213 Your next exhibit turns to recent actions by the ECB and related developments in financial markets. As noted earlier, gains in risky asset prices have been driven in part by a perception that the risks related to the European situation have been reduced. While several factors have likely contributed to this perception, the most important development has been the three-year liquidity operations (the LTROs) offered by the ECB. As shown in the upper-left panel, the three-year LTRO offered on February 29 was again met with substantial demand. This operation, in combination with the first LTRO back in December, boosted excess liquidity in the euro area to about €800 billion. At this point, the total amount of funding operations offered by the ECB stands at €1.1 trillion, with about 90 percent of that funding having a maturity of three years. These liquidity operations helped improve funding conditions for European banks, as the LTROs all but eliminated the risk that banks would not be able to meet the substantial borrowing needs that they face over the first half of this year.