Words may speak louder than actions for Federal Reserve Chairman Ben S. Bernanke when the time comes to outline plans to raise interest rates and shrink the central bank’s balance sheet.
Altering a pledge to keep short-term borrowing costs low or articulating plans to begin selling the $1.1 trillion in mortgage-backed securities it now holds will amount to a tightening of monetary policy because the announcements will send bond yields higher, raising borrowing costs, said Mitch Stapley, chief fixed-income officer at Fifth Third Asset Management in Grand Rapids, Michigan.
That means Fed officials may be more likely than traders anticipate to keep the benchmark federal funds target rate near zero through the end of the year, according to former Fed Governor Laurence Meyer. Bernanke’s challenge is to calibrate communications so he and his colleagues retain the flexibility to pace and time their actions to the strength of the recovery.
“This market is going to discount anything they do from the immediate moment that the words pass their lips,” said Stapley, who manages $13 billion in fixed-income assets. “The problem is the Fed needs the ability to work within shades of gray, and the market sees things in black and white.”
As the economy rebounds from the worst financial crisis since the Great Depression, the Fed must decide when to cease saying that economic conditions “warrant exceptionally low levels of the federal funds rate for an extended period,” a phrase it introduced in March 2009. It also must determine how to normalize a balance sheet that ballooned to a record $2.34 trillion after the purchase of $1.25 trillion of mortgage-backed securities.
An announcement outlining how the Fed plans to unwind its portfolio will likely widen by as much as 50 basis points the yields on agency mortgage bonds relative to benchmark rates, according to Scott Buchta, head of investment strategy at Guggenheim Securities LLC in Chicago.
Removing the “extended period” language would cause yields on two-year Treasury notes to increase by as much as 50 basis points in the following two weeks, said Paul Gifford, chief investment officer at 1st Source Investment Advisors in South Bend, Indiana. The notes yielded 81 basis points, or 0.81 percentage point, last week, according to Bloomberg data.
“You’re obviously going to see rates back up,” said Gifford, who manages $1 billion in fixed-income assets.
A majority of Fed officials, led by Bernanke, has resisted changing key phrases in the Federal Open Market Committee’s statement, even with three consecutive dissents from Thomas Hoenig, president of the Federal Reserve Bank of Kansas City. He says the “exceptionally low” for an “extended period” pledge risks creating asset bubbles and limits the central bank’s ability to raise rates.
The Fed will release minutes of its April 27-28 meeting next week, including updated projections of economic growth, inflation and unemployment from the 17 central bankers. In January, they projected a fourth-quarter jobless rate of 9.5 percent to 9.7 percent and expansion for the year ranging from 2.8 percent to 3.5 percent. The economy contracted 2.4 percent in 2009.
Employers added 290,000 jobs last month, the most in four years, as the unemployment rate rose to 9.9 percent from 9.7 percent, the Labor Department said May 7. The payrolls increase exceeded the median estimate of economists surveyed by Bloomberg News and followed a 230,000 gain in March that was larger than initially estimated.
The Fed introduced occasional public statements after interest-rate decisions in 1994, and since then its announcements have become “more of a policy instrument,” said J. Alfred Broaddus Jr., who served as Richmond Fed president from 1993 to 2004. While the statements became a regular feature in 1999, the wording wasn’t subject to a vote until 2000 and then only for a portion dealing with risks to the economy. FOMC members began voting on the entire statement in 2007.
The Fed sees “the communication as having a greater degree of flexibility than an actual move with the funds rate,” Broaddus said.
If market reaction to a plan for higher rates or home-loan bond sales were “really adverse and it shot mortgage rates from 5 percent to 6.5 percent, they could come out and say, ‘On second thought, we’re going to hold them,’” Fifth Third’s Stapley said.
The Fed will start selling mortgage-backed bonds by the end of 2010, Guggenheim’s Buchta predicted. That’s because the central bank owns a lot of lower-coupon securities exposed to so-called extension risk, when bonds remain outstanding longer than investors expect, he said.
Higher bond yields would raise borrowing costs for Washington-based Fannie Mae and McLean, Virginia-based Freddie Mac, which have been surviving on government aid since regulators seized the mortgage companies in September 2008.
“It’s important that they handle the announcing properly,” Buchta said.
Fed officials know from prior experience that they need to be careful. The central bank was in a similar situation in January 2004, when the federal funds target was 1 percent and policy makers had been saying since August 2003 it would stay low for a “considerable period.”
On Jan. 28, 2004, the Fed roiled markets when it unexpectedly dropped that phrase. Investors interpreted the change to mean a rate increase would come sooner than they anticipated, sparking a 1.4 percent decline in the Standard & Poor’s 500 stock index and a slump in Treasury prices.
“Language is more important than actions at this point, because the markets are very expectations-sensitive now, and language now has enormous impact on expectations,” said Gregory Hess, a former Fed researcher who’s an economics professor at Claremont McKenna College in California and a member of the Shadow Open Market Committee, a group of economists that critiques the Fed.
After the collapse of Lehman Brothers Holdings Inc. in September 2008 intensified the financial crisis, the central bank cut the federal funds rate target on overnight loans between banks to a record-low range of zero to 0.25 percent in December 2008 and has left it there ever since.
The Fed unveiled its program to buy agency mortgage bonds in November 2008 in an effort to bolster the housing market by reducing financing costs. The announcement sent yields on the securities down before the central bank actually began buying the debt in January 2009. Yields on Fannie Mae’s 4.5 percent mortgage bonds tumbled to 4.15 percent on Dec. 31, 2008, from 5.47 percent on Nov. 24, 2008, the day before the plan was revealed, Bloomberg data show.
The program succeeded in helping trim costs on new-home loans, with the average rate on a typical U.S. fixed-rate mortgage dropping to 5.12 percent on March 31, 2010, the day the program ended, from 5.98 percent on Nov. 24, according to Bankrate.com data.
As the economy has shown signs of recovering, the FOMC has already tweaked the tone of its statements. It added in November that its commitment to keeping rates at record lows depends on when the labor market, inflation and price expectations pick up.
Minutes of the March 2010 meeting said the pledge wouldn’t prevent officials from taking action when needed to keep inflation in check, while a few officials warned of the risks of increasing borrowing costs too soon.
Bernanke has signaled he’s in no rush to raise rates. In April 14 congressional testimony, he said the U.S. expansion will remain moderate as the economy contends with weak construction spending and unemployment near a 26-year high. The FOMC last month also reiterated that price growth is “likely to be subdued for some time,” which allows policy makers to delay any rate increases.
The Fed’s preferred inflation gauge -- the core personal-consumption expenditures price index, which strips out food and energy -- rose at an annual rate of 0.6 percent in the first quarter, the slowest pace since records began in 1959, according to an April 30 Commerce Department report.
“The life expectancy of ‘extended period’ is a lot longer than the markets think,” said Meyer, who served at the Fed from 1996 to 2002 and is now vice chairman at St. Louis-based Macroeconomic Advisers LLC. He expects the Fed will wait until the first quarter of 2011 to change the phrase and then raise the benchmark rate in the middle of next year.
“You change the language when you want the markets to believe that the rate increase is now very close,” he said.