Fed Gives Markets Clues on Exit Path From Unprecedented Easing
The Federal Reserve is trying to let investors know that, even as it pursues an unprecedented expansion of monetary stimulus, it hasn’t forgotten about exiting.
In the week after the Federal Open Market Committee’s Jan. 25-26 meeting, policy makers issued three announcements about expanding the number of counterparties for transactions that will help drain the record amount of cash added to the financial system. Brian Sack, the New York Fed’s markets-group head, added more details about the preparations in a Feb. 9 speech, and New York Fed President William Dudley reiterated last week that officials have the ability and will to withdraw their stimulus when necessary.
The disclosures come as a decline in the unemployment rate and growth in manufacturing underscore that the economic recovery is gaining momentum. Policy makers need to “communicate effectively” about their exit strategy to build confidence in the Fed and anchor inflation expectations, Dudley said Feb. 28 in a New York speech. The plan to buy $600 billion of Treasuries through June sparked the harshest political backlash against the Fed in three decades, with Republican lawmakers warning the stimulus risks a surge in prices.
Fed Chairman Ben S. Bernanke “has to convey to the market ‘I’m thinking about the exit and I have some plans in place,’” said John Silvia, chief economist at Wells Fargo Securities LLC in Charlotte, North Carolina. Silvia said Bernanke faces the same challenge President Barack Obama does in saying he wants the budget deficit under control: “You’ve got to have a plan.”
The Fed is about halfway through its $600 billion asset- purchase program, or so-called quantitative easing, which was dubbed “QE2” by analysts and investors because it followed an earlier round of $1.7 trillion in bond buys that ended in March 2010. Policy makers “continue to regularly review” the purchases and will adjust them “as needed” to achieve the central bank’s dual mandate of full employment and price stability, Bernanke told the Senate Banking Committee March 1.
“We have all the tools we need to achieve a smooth and effective exit at the appropriate time,” Bernanke said.
Rising stock prices, lower corporate-borrowing costs and an improvement in economic data have fueled speculation that the Fed may be nearing the end of its record monetary expansion after keeping its benchmark rate near zero since December 2008 and expanding its balance sheet to a record $2.55 trillion. The unemployment rate unexpectedly fell to 8.9 percent in February, the lowest in almost two years, and employers added 192,000 jobs in a sign of growing confidence in the rebound, which began in the third quarter of 2009.
Talk ‘Is Cheap’
“Talking about your commitment to keep inflation at a low level is cheap, but it’s certainly one arrow in the Fed’s quiver and they’re going to use that,” said Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut. “Clearly Fed officials are very cognizant” of the risk that “the markets say ‘the Fed is messing this up,’ and inflation expectations come unhinged.”
The break-even rate for 10-year Treasury Inflation Protected Securities, the yield difference between this debt and comparable maturity Treasuries, rose to 2.57 percentage points on March 8, the highest since July 2008 and up from 1.63 percentage points on Aug. 27, the day Bernanke said additional securities purchases might be warranted. The rate is a measure of the outlook for consumer prices during the life of the securities.
While the Fed hasn’t committed to the specific tools it will use, or in what order, it has been releasing details about its progress in building new programs and expanding its ability to drain reserves.
On Jan. 31, the New York Fed announced it added 32 money- market mutual funds as potential reverse-repo counterparties. The next day, the central bank reduced by half the amount of assets that money-market funds must hold to become counterparties, and on Feb. 2 the New York Fed named New York- based MF Global Holdings Ltd. (MF) and Societe Generale (GLE) SA in Paris as primary dealers. They were the first companies since July 2009 to join the network of securities firms that act as counterparties to the central bank’s transactions.
In a reverse repo, the Fed lends securities for a set period, draining bank reserves from the financial system. At maturity, the securities are returned to the Fed, and the cash to the primary dealers.
The Fed conducted tri-party reverse repurchase agreements with money funds in October as part of its preparations. It was the first time the Fed conducted the operations with counterparties other than its primary dealers. In a tri-party arrangement, a third party functions as the agent for the transaction and holds the security as collateral.
‘A Lot of Skepticism’
“There’s a lot of skepticism of the scale at which the Fed can operate with some of these programs,” given that several of the tools are new and the central bank has never had so much liquidity to withdraw, Stanley said. “People are trying to get a sense of whether this stuff will actually work.”
Officials may use their new Term-Deposit Facility to help tighten monetary policy. Sack said Feb. 9 that more than 500 depository institutions have registered for the program, which pays banks a premium on their funds in exchange for leaving their money in the facility and is designed to help raise the Fed’s target interest rate for overnight lending between banks.
The Fed could choose to sell assets or raise the interest it pays on excess reserves, a tool it was granted in 2008. It also may decide to drain money from the banking system by “ceasing the reinvestment of principal payments on the securities it holds,” Bernanke said March 1, reversing a policy begun in August.
“It’s a more complicated exit strategy than usual, and it’s not just a matter of saying ‘the Fed funds rate has risen,’” said Dean Maki, chief U.S. economist at Barclays Capital in New York. “They also have this bloated balance sheet and have to decide how quickly to run that off, and whether to use term deposits and reverse repos. There are a number of complicated choices to be made.”
Gregory Habeeb, who manages $7.8 billion in fixed-income assets at Calvert Asset Management Co. in Bethesda, Maryland, said the Fed’s policies are fueling asset bubbles in the stock and bond markets. Habeeb says he “doesn’t buy it at all” that the central bank will pull its stimulus in time, so he is being cautious about taking on what he regards as too much interest- rate or credit risk in his funds.
The Standard & Poor’s 500 Index of stocks climbed to 1,320.02 yesterday, up 24 percent since Aug. 27. The extra yield, or spread, investors demand to own high-yield, high-risk securities instead of Treasuries has narrowed to 4.71 percentage points from 6.81 percentage points in the same period, according to Bank of America Merrill Lynch index data.
“There’s this bubble that’s growing that they helped create, and they themselves say ‘We can’t spot them’ so they’re not going to do anything” in time, Habeeb said.
At the January FOMC meeting, policy makers differed over whether the strengthening U.S. recovery merited reducing or slowing their stimulus.
They also discussed the risk that “the very large size” of the Fed’s balance sheet could lead “the public to doubt the Committee’s ability to withdraw monetary accommodation when doing so becomes appropriate,” according to the minutes of the meeting. To that end, the FOMC should “continue its planning for the eventual exit,” the minutes said. The next meeting is March 15.
Dudley, who is also vice chairman of the policy-setting committee, said Feb. 28 that the main inflation risk is that expectations climb, which could happen if there is a “loss of confidence” in the U.S. central bank’s ability to withdraw its funds in time to ward off a surge in prices.
“If inflation expectations were to become unanchored because Federal Reserve policy makers failed to communicate clearly, this would be a self-inflicted wound that would make our pursuit of the dual mandate of full employment and price stability more difficult,” Dudley said.
The central bank will boost interest on excess reserves to keep inflation from accelerating too quickly, and the new tool is “viable” for “keeping the economy from overheating,” Dudley said.
The talk about the exit hasn’t been enough to convince Barclays’ Maki that the Fed will get it right.
“The real issue in my view is not whether they have the tools, but whether they use them in a timely enough manner to prevent inflation or asset bubbles from arising,” Maki said.
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