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FOMC to debate QE program tweaks at final meeting of 2020

As the Federal Open Market Committee begins its final meeting of the year, the major question for investors is whether the central bank will adjust its quantitative easing program to apply more downward pressure to long-term interest rates.

But with rates already near historical lows and COVID-19 vaccines starting to be rolled out, some analysts believe the Federal Open Market Committee will avoid making major changes at its Dec. 15-16 meeting. Others think the Fed will opt for more stimulus by tilting its $80-billion-per-month Treasury purchase program toward longer-term securities — a strategy aimed at nudging down long-term rates that influence big consumer purchases like homes.

The benchmark 10-year Treasury yield, however, remains below 1% and continues to fuel the residential real estate market and drive record levels of corporate debt. Fed officials have also made few indications in recent weeks that they think more accommodative Fed policy is necessary at this point, and they have reiterated their view that more fiscal support from Congress is needed.

"We need a fiscal bridge being built here, because the Fed's done really everything it can, and monetary policy is a much more blunt policy tool" than targeted spending from Congress, said Karissa McDonough, chief fixed income strategist at People's United Advisors.

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The tone from Fed Chairman Jerome Powell's news conference will likely be a bit more optimistic following the emergency authorization of a COVID-19 vaccine from Pfizer Inc. and BioNTech SE. But analysts say he will also offer a dose of reality and highlight that the economic recovery is far from complete, with millions of Americans still out of work and many small businesses at risk of closing up permanently. Talks over more fiscal support for unemployed workers and hard-hit businesses have also dragged on in Congress, with some signs of progress emerging this week.

In one sign of a slowing recovery, initial claims for unemployment benefits surged to 853,000 in the week ended Dec. 5, the highest level in over two months. Local officials have also begun to reimpose restrictions on dining and other economic activity as COVID-19 cases see a holiday-season spike.

"The next few months are going to be very tough," said Nisha Patel, director of fixed income portfolio management at Parametric Portfolio Associates.

The potential for more economic weakness has prompted some analysts, including J.P. Morgan Chief U.S. Economist Michael Feroli, to state they expect the Fed to shift its Treasury purchases more toward longer-dated securities. Feroli said the case for such an action is "straightforward," but he noted on Dec. 11 that his confidence that the central bank will do so has waned given recent commentary from Fed officials.

Dallas Fed President Robert Kaplan, for example, told CNBC on Dec. 2 that he "would not want to do that at this point."

"I'll go into the December meeting with an open mind. But I think we've got very accommodative financial conditions, we've got historically low rates on the long end, and so I don't know that increasing the size or extending maturities of our bond purchases would help address this situation that I'm concerned about over the next three or six months."

The Fed may prefer to hold off on that step until next year, but it could also opt for a surprise given that it has "consistently out-doved even the most dovish expectations throughout the pandemic," wrote Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets, in a research note.

"Regardless of the outcome, some subset of the market will be caught offsides," Lyngen wrote, adding that his clients appear divided on whether the Fed will opt for more stimulus.

While the debate around the mix of Treasury purchases continues, analysts are ruling out the possibility of the Fed increasing the amount it is purchasing. The central bank is currently buying $80 billion in Treasury securities and $40 billion in mortgage-backed securities each month, a far smaller pace that its initial flood of purchases early in the COVID-19 pandemic but one that Fed officials appear comfortable with.

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The Fed is likely to provide clearer guidance on how long those purchases will continue, however. The current FOMC statement indicates the purchases will stay at least at the current pace "over coming months," but most Fed officials agreed at their November meeting that language was due for an update.

Most favored shifting toward "qualitative outcome-based guidance" for the asset purchases, according to minutes of the November gathering. That approach would tie the future of the program more closely to economic conditions, while still giving the Fed some flexibility to decide when to begin dialing it down. A few Fed officials, though, had been hesitant to make any changes to the guidance given the "considerable uncertainty" around the economic outlook.

The goal of clarifying the guidance would be to emphasize that the purchases will continue as long as economic conditions warrant, as well as to avoid any possible "taper tantrum" in the future if markets start to worry that the Fed will begin to tap the brakes prematurely, said McDonough, the People's United Advisors strategist.

Investors' optimism over the vaccine has already contributed to some uptick in the benchmark 10-year Treasury yield, which tends to rise when the economic outlook improves. But it remains below the critical threshold of 1%, and Fed action to nudge it down a few basis points is unlikely to be "super stimulative," she added.

"If it's drifting upwards for the right reasons like the economy is actually starting to heal and inflation is starting to tick up then that's OK," McDonough said. "I don't think they want to control that."

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