With Operation Twist's imminent conclusion, the Federal Reserve took the expected step of launching another round of large-scale asset purchases. It also added an element of surprise and transparency by tying its current, exceptionally low fed funds rate to specific unemployment and inflation targets. And with these guidelines set, the Fed also appeared to clarify the future sequence in which it would start removing this policy accommodation.

In keeping the fed funds rate at 0–0.25%, the Fed explained that this range will be appropriate at least as long as the unemployment rate remains above 6.5%, short-term inflation is no more than 2.5%, and long-term inflation expectations remain anchored. This is a stark difference from its previous indications that the fed funds rate would remain at exceptionally low levels at least through mid-2015. The Fed did add, however, that the new economic targets are in line with the prior calendar guidance. Indeed, the Fed's latest economic projections do not see an unemployment rate below 6.8% until 2015, which, incidentally, extends beyond Fed chairman Ben Bernanke’s current term that ends in 2014.

While the combination of these economic targets should determine the timing of a movement in the fed funds rate, it also appears that the Fed's quantitative easing programs will end well before those targets are reached. This is consistent with the Fed's statement that "a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens."

Therefore, some notable improvement in the unemployment rate and the end of the asset-purchase programs should precede any increase in the fed funds rate. This reiterates some of the unwinding steps Bernanke laid out in 2010, but now clarifies that a subsequent movement in the fed funds rate will now be dictated by the aforementioned unemployment and inflation levels.

The timing of the announcement tying monetary policy to economic conditions may have surprised some observers because this approach could affect the flexibility of the Fed to react to changing conditions. When compared to the calendar-based guidance, which had been adjusted multiple times, the new economic-based guidance appears to set firmer targets for the Fed.

Although specifying its economic targets should provide investors with additional transparency into monetary policy, any start to an unwinding process remains on the distant horizon. This distance is underscored by the latest round to the Fed's large scale asset purchases, which will initially add $45 billion of long-term Treasuries per month to the Fed’s balance sheet. This is in contrast to the sterilized effects of Operation Twist, which had a neutral impact on the size of the balance sheet because of the accompanying sales of short-term securities.

When combined with the previously announced purchases of monthly agency mortgage-backed securities (MBS), the latest quantitative easing announcement heralds a monthly expansion of $85 billion in the size of the Fed's balance sheet. This pace also would be about $10 billion more per month than what occurred during QEII. (See Table 1 for details of the various rounds of asset purchases.) And at this rate, the balance sheet is on a trajectory to expand from $2.86 trillion (as of mid-December 2012) toward $4 trillion, and possibly beyond, as the asset purchases proceed.¹

The timing of Operation Twist's conclusion was largely dictated by the rapid decline of short-term securities held by the Fed. This shift in composition of the Fed's balance sheet has also been reflected in the surge of its holdings of Treasury securities that mature in five to 10 years. As of December 5, 2012, the Fed held $847 billion of Treasuries in this category, 30% more than it held at the beginning of the year.²

If the Fed had not announced a new program of asset purchases, some observers might have regarded this as a step toward tightening policy considering the curtailed flow of liquidity from the Fed even as it retained a huge stock of securities on its balance sheet. This appearance of contraction—and the increased potential for volatility in long-term interest rates—would be the opposite message the Fed would have wanted to send in an approaching environment that will likely feature less fiscal stimulus.

With the Fed's latest purchases targeting long-term Treasuries, an eventual unwinding process also could have the largest effect on this segment of the market, which has led to some concerns about volatility in long-term interest rates.

Although the Fed did not provide specific guidelines for its asset purchases, the vast distance to its fed funds targets indicate that these purchases should continue for the foreseeable future, thus mitigating prolonged bouts of volatility in long-term interest rates.

In establishing the specific targets for short-term interest rates, the Fed seemed to reiterate some familiar themes. One is to strengthen its message that the fed funds rate of close to zero will not be changing anytime soon. And another is that the Fed's balance between its two mandates of maximum employment and price stability continues to shift towards reducing unemployment at the cost of tolerating faster rates of inflation.