Fed considering upping QE3 size and language

At its two-day meeting that starts Tuesday, the Fed may abandon its calendar date.approach to forward guidance and adopt some form of numerical target for policy, analysts said.

Reuters Federal Reserve Chairman Ben Bernanke (left) speaks with Charles Evans of the Reserve Bank of Chicago in August. The approach of Evans is slowly being adopted by his Fed colleagues.

And the central bank consider whether to expand its bond-buying at the end of the year to take account of Treasury purchases under its Operation Twist plan that finishes at year-end.

No final decisions are expected when the Federal Open Market Committee releases a statement at 2:15 p.m. Eastern on Wednesday. Economists will parse the summary of the Fed’s deliberations to be released in November 15 for clues to what actions may come at the last meeting of the year in mid-December.

After the drama of the central bank’s meeting in September, this week’s meeting is viewed as less of a cliff hanger.

Last month, the Fed announced a plan to purchase $40 billion of mortgage-backed securities per month in an open-ended approach that would not be stopped until the labor market improved.

While it may not sound like much, the Fed may buy over $1 trillion in MBS based on current forecasts, analysts at Capital Economics estimate.

The Fed also took the dramatic step of saying it expects to keep short-term interest rates unchanged even if the recovery strengthens. It also pushed out the calendar date for the expected first rate hike until mid-2015. Read complete analysis of Fed’s September actions

There are no pressures on the Fed for immediate action on these two fronts, economists said.

“I think they are reasonably comfortable with the market reaction [to QE3] and the way the economy has turned out,” said Michael Hanson, economist with Bank of America Merrill Lynch.

“The Fed has entered a holding pattern while watching for signs of a substantial improvement in the labor market,” added Ellen Zentner, senior U.S. economist for Nomura Securities.

At the moment, the Fed is buying $45 billion of long-term Treasurys each month under its Operation Twist program, with the purchases offset by sales of shorter-term securities.

Many economists think the Fed will decide to expand QE3 by that amount, and with Treasurys instead of MBS. But the announcement is not expected to come until its December meeting.

Several Fed officials have spoken in favor of expanding QE3. Read: Fed’s next move: Buy more Treasurys

The proposal to abandon calendar dates from its guidance would work along the lines of a plan advocated by Charles Evans, the president of the Chicago Fed. Evans wants the Fed to tell the market that it would keep rates near zero, as long as unemployment remains above 7% and as long as inflation does not threaten to rise above 3%.

The biggest monetary policy development since the last Fed meeting was that Narayana Kocherlakota, the president of the Minneapolis Fed, who also came out in support of numerical targets.

In what one Fed watcher called a plot twist out of an Alfred Hitchcock movie, Kocherlakota called on the Fed to hold interest rates at zero for another four years until the unemployment rate hits 5.5%. Only a few months earlier, Kocherlakota had advocated a rate hike before the end of this year. Fed’s Kocherlakota surprises with dovish stance.

Only if inflation move higher than 2.25% would the Fed need to hike rates, Kocherlakota said.

Finding the right set of numbers for triggers will be a challenge for the Fed, analysts said.

“I don’t know if they will ever agree,” said Hanson.

Mike Moran, chief economist at Daiwa Securities America, noted that Kocherlakota and Evans are far apart on their inflation triggers.

The Fed is also working on a consensus forecast of the 12 voters on the interest-rate-setting committee. At the moment, the Fed provides a summary of individual policymakers’ forecasts.

A consensus forecast is the first step towards numerical targets, said Tom Porcelli, economist at RBC Capital.

Depending on how much progress is made on the issue this week, a consensus forecast could be released in December, economists said.

Bernanke has yet to provide any guidance of his preferred approach, noted Milan Mulraine, economist with TD Securities.