Two Federal Reserve economists are telling the Street what it already suspected: Dovish talk may be even more powerful than quantitative easing.
In a research note, the economists wrote that the Federal Reserve's asset purchases, or quantitative easing, probably provided a "modest boost to economic growth and inflation." However, the effects of QE would depend in large part on the Fed's interest-rate guidance, the note said.
"[E]stimates from a macroeconomic model suggest that such interest- rate forward guidance probably has greater effects than signals about the amount of assets purchased," the economists wrote in the paper, released by the San Francisco Federal Reserve.
The paper, which was not an official Fed policy statement, was by Vasco Curdia, a senior economist at the Economic Research Dept. of the San Francisco Fed and Andrea Ferrero, a senior economist at the New York Fed. It landed during a relative news void Monday, and as many traders wonder when the Fed will begin tapering its asset purchases. Therefore, it quickly became a topic du jour among the trading community, and some read it as a document in support of tapering.
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"Everybody's focused on the ending of the asset purchases, leaving aside the forward guidance and what the research has continued to support from the Fed's point of view—the promise to keep rates low is as effective, if not more effective, than the outright purchase of assets," said Daniel Greenhaus, global market strategist at BTIG.
This summer as talk of the Fed "tapering" its $85 billion a month in bond purchases picked up, Fed officials were careful to emphasize that they had no intention of raising short-term interest rates anytime soon.
The Fed economists pointed to QE2, a $600 billion large scale asset-purchase program, noting it added about 0.13 percentage points to real growth in late 2010 and 0.03 percentage points to inflation.
"Our analysis suggests that forward guidance is essential for quantitative easing to be effective. Without forward guidance, QE2 would have added only 0.04 percentage point to GDP growth and 0.02 to inflation," the economists wrote in the paper.
The Fed undertook the extraordinary easing program to boost economic growth and put inflation at more normal levels. QE was a new program the Fed pulled from its tool box to inflate asset values and prevent the economy from double-dipping.
The paper relies heavily on model assumptions, said John Briggs, senior Treasury strategist at RBS. So, "[i]t's hard to be heavily critical one way or the other. It probably feels about right, that it was an eighth of a point of GDP over time, with fading impact as it goes on and fading impact from the first program to the second program to the third program. It's logical to me that guidance reinforces asset purchases because it helps lower the term structure of interest rates."
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The Fed economists said their analysis showed that "communication about when the Fed will begin to raise the federal funds rate from its near-zero level will be more important than signals about the precise timing of the end of QE3."
Briggs said the forward guidance does appear to be a more powerful tool. "If you say for five years we're not going to raise rates, you flatten that end of the curve. If you're purchasing the long end of the curve, you're flattening the entire (Treasury yield) curve. My feeling is the forward guidance is more powerful than asset purchases. The paper reinforces that," he said.
—By CNBC's Patti Domm. Follow her on Twitter @pattidomm.