As we tick down the hours to the most watched Federal Reserve policy statement in recent memory, it's worth taking a quick tour through current policy with an eye to what might change.
The Size of Large Scale Asset Purchases (aka QE)
The Fed is currently buying $85 billion of bonds per month. It buys $40 billion of mortgage-backed securities and $45 billion of longer-term Treasury bonds.
What to watch for: The Fed is widely expected to reduce the size of the bond buying program. Most Wall Street economists predict a reduction—or taper—of between $10 billion and $15 billion. Many believe that the Fed will concentrate on reducing the size of the Treasury purchases, although a minority think the Fed will also reduce the mortgage-backed security purchases as well.
What would be surprising: Any reduction below $10 billion or above $20 billion would be unexpected. Similarly, a larger reduction in MBS buying than Treasury bonds would also surprise many.
The End of QE and the Unemployment Threshold
The last statement from the FOMC said that the purchases would continue "until the outlook for the labor market has improved substantially." At his press conference in June, Ben Bernanke clarified this by saying that the Fed would likely be in a position to end QE altogether when unemployment hits 7 percent. Bernanke said the Fed's forecast for hitting 7 percent was the middle of 2014.
What to watch for: There are several variables that could change. The most likely change would be the Fed adjusting its forecast for hitting the 7 percent target. If the Fed thinks the economy has been outperforming its earlier forecast, the target date could move forward to the first half of 2014. More likely, the Fed would read recent economic numbers as indicating that it isn't quite on target. That would mean that the 7 percent target would be shifted back to the later half of 2014.
One question is whether the target and the forecast will make it into the actual statement or remain a part of Bernanke's press conference. A movement into the statement would signal that the Fed is trying to firm up expectations around these numbers.
What would be surprising: The Fed or Bernanke could change the 7 percent target, lowering it down to 6.5 percent. It's very unlikely the target would change in the other direction.
Interest Rate Forward Guidance
In the last statement, the Fed said that its "highly accommodative" stance on monetary policy would remain appropriate "for a considerable time" after QE ends. It also said that the exceptionally low Fed funds rate would be appropriate as long as the unemployment rate remains above 6 ½ percent and two years forward-looking inflation projections remain below 2.5 percent.
What may change: It seems unlikely anything here will change.
What would be surprising: Any change in this language would be highly surprising. Look out for a lot of volatility if there is any change to the forward guidance on rates.
Current Economic Conditions
Here's what the Fed said last time about the economy:
- economic growth will pick up from its recent pace,
- the unemployment rate will gradually decline,
- the downside risks to the outlook for the economy and the labor market have diminished
- inflation persistently below its 2 percent objective could pose risks to economic performance, but the anticipates that inflation will move back toward its objective over the medium term
The Fed seems to have gotten this call correct. Revisions to second quarter GDP show the economy accelerated sharply. Inflation is still low and slowed a bit in August, but is probably not inconsistent with the Fed's anticipation of moving back toward its objective over the medium term. Unemployment has been declining, although in a context of very low jobs growth.
What could change: The Fed could change its outlook on economic growth for the second half of the year, although it would be odd to change in a pessimistic direction at the same time in announces a QE taper. Perhaps more likely the Fed could talk about the labor market more broadly, noting the low growth in jobs and low labor market participation rate.
What would be surprising: Any dramatic change here would be surprising, in a bullish or bearish direction.
—By CNBC's John Carney. Follow me on Twitter