April 21 (Bloomberg) -- The Federal Reserve can be counted on to keep its balance sheet big and interest rates low if President Barack Obama and Republican lawmakers agree on a multi-year deal to slash the $1.4 trillion budget deficit.
That’s the message from the Treasury bond market, where yields on 10-year securities sank to their lowest level in almost a month this week on speculation that government budget cuts will slow the economy and encourage the Fed to hold off from raising borrowing costs, said Mohamed El-Erian, chief executive officer of Pacific Investment Management Co.
“The more fiscal austerity you get, the more likely that the Fed will stay on hold for longer,” El-Erian, whose Newport Beach, California-based company runs the world’s biggest bond fund, said in an April 19 interview on Bloomberg Radio’s “Surveillance” with Tom Keene.
A 10-to-15 year agreement to stabilize and then reduce the ratio of federal debt to gross domestic product would trim U.S. economic growth by a quarter to a half percentage point a year, according to a scenario run by Englewood, Colorado-based consultants IHS. The Fed probably would try to mitigate that impact by tightening credit more slowly than it otherwise might, said IHS Chief Economist Nariman Behravesh.
The yield on 10-year notes was 3.41 percent at 9:03 a.m. in London, according to Bloomberg Bond Trader prices. That’s more than a half-percentage point below the average of about 4 percent during the past 10 years, based on data compiled by Bloomberg. It’s also lower than the 3.74 percent high for this year, set on Feb. 8.
Plot Monetary Strategy
Central bank Chairman Ben S. Bernanke and his colleagues likely will affirm their pledge to complete $600 billion in purchases of Treasury debt by the end of June when they meet next week to plot monetary strategy, said Neal Soss, chief economist for Credit Suisse Holdings USA Inc in New York.
The question then facing the Fed would be when to start withdrawing stimulus from the economy, with the first step likely to be a decision to reduce its balance sheet by not reinvesting into Treasuries the proceeds of maturing debt.
Fed officials were divided at their last meeting over the timing of tightening, according to the minutes of the March 15 gathering. While a few suggested a move might be warranted this year, “a few others noted that exceptional policy accommodation could be appropriate beyond 2011.”
Most of the 50 analysts in a Bloomberg News survey last month said they expect the Fed will keep its bond portfolio stable for some time after the $600 billion purchase program ends. A plurality of 16 saw the central bank waiting four to six months before allowing its balance sheet to shrink.
The Fed might delay a decision into next year if Obama and Congress tighten fiscal policy sooner and more sharply than the central bank already anticipates, said Roberto Perli, managing director at International Strategy & Investment Group in Washington and a former Fed official. That also would delay the timing of the Fed’s first interest-rate increase, he added.
Futures markets in Chicago see a more than one-in-three chance that the central bank will raise its target for the federal funds rate by January 2012. The target for the rate banks charge each other on overnight money has been zero to 0.25 percent since December 2008.
Former Fed Governor Laurence Meyer said he is sticking with his forecast that policy makers will increase the rate in January, though he added that “steeper spending cuts would put pressure” on that call.
“Monetary policy should always offset what fiscal policy does” to the economy, said Meyer, who is now vice chairman of St. Louis-based Macroeconomic Advisers. Bernanke “would never say that, but that is the case.”
The economy already looks set to suffer a fiscal hit to growth of about one percentage point next year as a temporary cut in payroll taxes and other stimulus measures expire, said Mark Zandi, chief economist in West Chester, Pennsylvania, at Moody’s Analytics. Any budget pact would be on top of that.
Fed Vice Chairman Janet Yellen told the Economic Club of New York last week that she hadn’t figured in the possibility of a “substantial package to tighten fiscal policy” during the central bank’s last quarterly forecasting round.
At the Jan. 25-26 meeting, the Federal Open Market Committee generally saw the U.S. expanding by 3.4 percent to 3.9 percent this year and 3.5 percent to 4.4 percent in 2012. Bernanke will present the group’s updated forecasts at his first press conference on April 27.
Hopes of a multi-year budget deal have grown after Obama and House Republicans presented separate programs this month to rein in the deficit and debt.
“I am feeling far more optimistic about resolving this issue now than I was several months ago,” former Fed Chairman Alan Greenspan said on NBC’s “Meet the Press” television program April 17.
El-Erian also said he’s become more hopeful about an agreement, though he cautioned that “there are still hard decisions to be made.”
While Obama and Republicans in the House of Representatives both want to reduce cumulative budget deficits by $4 trillion, they disagree over the speed and means to do so. Obama has called for a “balanced” approach that combines spending cuts with tax increases to achieve the $4 trillion objective in 12 years. Republicans want to use only expenditure reductions to accomplish the goal in 10 years.
The announcement this week by Standard & Poor’s that the U.S. government risks losing its AAA credit rating increases pressure on Obama and Republicans to strike a deal.
“S&P’s outlook certainly adds to motivation in Washington to confront our fiscal challenges,” said Tony Fratto, who served as a White House and U.S. Treasury official under President George W. Bush.
New York-based S&P said there’s a one-in-three chance it might cut the rating within two years, adding its “baseline assumption” is that Congress and the Obama administration will come to terms on a program to reduce the deficit.
Treasury Secretary Timothy F. Geithner voiced confidence political leaders will bridge their differences and move toward a long-term plan to narrow deficits and reduce the debt.
“We have an opportunity now over the next two months to make some real progress,” Geithner said in an April 19 interview on Bloomberg Television. “What we agree on is putting in place strong targets for savings, deficit reduction over a specific time frame with enforceable limits.”
House Republicans have warned that they won’t vote to increase the country’s $14.29 trillion debt limit unless it’s accompanied by steps to reduce the deficit. The Treasury has said the borrowing limit will be reached no later than May 16, at which point it will turn to emergency measures that provide borrowing room through about July 8.
“We won’t raise, just simply raise, the debt limit,” House Budget Committee Chairman Paul Ryan, a Wisconsin Republican, said April 17 on CBS’s “Face the Nation” television program. “We will vote to have spending cuts and controls in conjunction with the debt-limit increase.”
To contact the reporter on this story: Richard Miller in Washington at firstname.lastname@example.org
To contact the editor responsible for this story: Christopher Wellisz email@example.com