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The Fed's Cautious Return to Normalcy

In slowing mortgage-debt purchases, the FOMC signals that Ben Bernanke's Federal Reserve is trimming stimulus measures. Are reverse repos next?

Like a cautious firefighter turning off the hoses one by one, the Federal Reserve is gradually scaling back the extreme measures it embraced to prop up the U.S. economy. On Sept. 23 the Fed took another step, announcing that it will stretch out by three months its schedule for purchasing mortgage debt to damp down mortgage interest rates and support the housing market. Instead of completing the $1.45 trillion in purchases by the end of 2009, it will complete them by the end of March 2010. That slowdown in the rate of purchases is like cranking down a hydrant to reduce the flow of water to the fire.

The Fed's gradual approach to removing stimulus is evidence that the recession-fearing doves "have the upper hand" in the debates vs. the inflation-fearing hawks, says Julia Coronado, a former Fed staffer who is senior U.S. economist for BNP Paribas. That partly reflects the influence of Fed Chairman Ben Bernanke, who has repeatedly warned that the economy is not yet on solid ground. Says Coronado: "Chairman Bernanke is a stronger leader than is sometimes perceived." The vote in favor of the monetary policy actions was once again unanimous—including inflation hawk Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, Va.

The Fed's announcement of the latest phase of its exit strategy came at the end of a two-day meeting of the rate-setting Open Market Committee. With the economy still weak, the committee kept in place its most important stimulus—namely, holding the federal funds rate at a rock-bottom zero to 0.25%. Some economists worry that such low rates on overnight loans between banks are fueling speculation in the stock and bond markets and could ignite inflation in goods and services. But the official statement gave no hint that the Fed is about to shut off that hose, saying the committee "continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

The Federal Open Market Committee noted that economic activity, financial conditions, and housing have improved since the committee last met in August. On the downside, it said that household spending "remains constrained" by job losses, sluggish income growth, the fall in home values, and tight borrowing conditions. It said businesses are still cutting back on investment and jobs. The Fed said it expects that "inflation will remain subdued for some time."

A possible next step in the Fed's exit strategy would be to begin draining some of the enormous reserves that have piled up on banks' balance sheets over the past year. The technique for doing that is a transaction called a reverse repurchase agreement, or reverse repo for short. The Federal Reserve Bank of New York has told the banks with which it deals directly to be ready to conduct such transactions, but nothing has been ordered yet.

Coy is BusinessWeek's Economics editor.

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