One of Janet Yellen’s first challenges as Federal Reserve chairman will be figuring out how to cushion against a lurch in interest rates when she pares the pace of the central bank’s bond buying.
After sending 10-year Treasury yields more than a percentage point higher by fueling taper expectations in May and June, policy makers now are grappling with their options when they do reduce debt purchases that have swelled their balance sheet to a record $3.91 trillion.
The Fed’s failure so far to convince investors that tapering on its own doesn’t constitute a tightening of policy creates the risk of more market volatility as the central bank communicates about tools it’s never used.
“Now, this is challenging: We’re in unprecedented circumstances, we’re using policies that have never really been tried before -- and multiple policies -- and we’re trying to explain to the public how we intend to conduct these policies,” Yellen, the nominee to replace Ben S. Bernanke, told the Senate Banking Committee Nov. 14 at her confirmation hearing in Washington. “So, it is a work in progress, and sometimes miscommunication is possible.”
Since lowering their benchmark interest rate to near zero in December 2008, Fed officials have relied on bond buying and forward guidance about their plans to try to spur growth. They’ve suggested pushing back the timeline for rate increases, emphasizing they won’t raise borrowing costs until inflation climbs, or lowering the interest they pay on the cash that banks park at the central bank as ways to add stimulus.
“It’s been a struggle,” said Ward McCarthy, chief financial economist at Jefferies LLC in New York. “With the shift to balance-sheet policy, there’s not a whole lot to fall back on -- both in terms of making decisions on how to conduct balance-sheet policy and how to communicate it. It’s a new experience both in and out of the Fed.”
Yellen, who is currently vice chairman, told the senators that central bankers “certainly want to diminish any unnecessary volatility” and are “trying as hard as we can to communicate clearly.”
The Fed is buying $85 billion of mortgage-backed securities and Treasuries each month. It will slow these purchases in March, according to the median estimate of 32 economists in a Bloomberg News survey conducted Nov. 8.
McCarthy predicts the Fed will try to push back expectations for an interest-rate increase to 2016 -- though he’s not sure how. He also said the Fed may cut purchases of short-term debt and maintain the pace of buying longer-term securities in an effort to anchor borrowing costs.
The policy-setting Federal Open Market Committee’s Sept. 18 decision not to taper surprised investors across the globe after Bernanke outlined in May and June a possible timetable for reducing quantitative easing.
On June 19, he said he might trim the pace of securities purchases this year and halt them by mid-2014. His comments sent yields on the benchmark 10-year Treasury note as high as 2.99 percent on Sept. 5 from 1.93 percent on May 21. Bernanke cited the rise as one reason why the Fed chose to maintain the pace of its stimulus in September.
Yields since then have fallen to 2.67 percent at 4:59 p.m. yesterday in New York as traders pushed back expectations for a taper, Bloomberg Bond Trader data show.
Fed officials have been “a little bit naive about the way the bond market responds to the exit” of their record accommodation, said Ethan Harris, co-head of global economics research at Bank of America Corp. in New York. “The Fed kept on insisting that tapering was a small move, but it’s not small symbolically.”
Harris, one of the few economists to correctly predict the Fed wouldn’t taper in September, said he expects the central bank to extend its outlook for raising rates, in part because inflation is falling short of its 2 percent goal. Prices are accelerating at a 0.9 percent annual rate, the personal-consumption-expenditures price index showed in September.
“Inflation is too low,” though “it wouldn’t mean they don’t taper as they’re much more comfortable with forward guidance and interest rates than they are with the ever-expanding balance sheet,” Harris said.
The FOMC has pledged to keep its benchmark rate near zero so long as the jobless rate remains above 6.5 percent and the outlook for inflation doesn’t rise above 2.5 percent.
William English, an economist for the Fed Board of Governors, wrote in a paper this month that the strategy of linking higher rates to the unemployment peg has provided effective stimulus, and an even-lower threshold could be helpful. Joblessness was 7.3 percent in October.
James Bullard, president of the Federal Reserve Bank of St. Louis, said in a Sept. 20 interview in New York that introducing an inflation floor is a “more likely” way for policy makers to adjust their forward guidance than lowering the unemployment threshold. The price-acceleration floor would be something like: “so long as inflation was running below 1.5 percent,” the Fed wouldn’t raise interest rates, Bullard said.
U.S. central bankers probably will cut their monthly quantitative easing in January by $10 billion and will extend the outlook for an increase in interest rates at a later point because it would be “too confusing to markets” to do both at the same time, Harris said.
Asset purchases and communications about the path of policy rates are “discrete tools that can be deployed independently or in varying combinations,” Atlanta Fed President Dennis Lockhart said Nov. 12 in a speech in Montgomery, Alabama. “They can be thought of as a particular policy-tool mix chosen to fit the circumstances at this particular phase of the recovery,” and “going forward, it may be appropriate to adjust” the mix.
Some investors still are convinced there could be another market rout once the Fed reduces its bond buying.
“It probably won’t be any different when the Fed ultimately is forced to taper: What you saw in May and June of this year was simply the dress rehearsal for the main event,” said Tad Rivelle, chief investment officer for fixed income in Los Angeles at TCW Group Inc. “This is a period where you start to skinny down and shrink your risk exposure.”
Cutting the 0.25 percent rate the Fed pays on bank reserves would help reinforce the Fed’s message that it intends to keep monetary policy easy even as it starts to reduce its asset purchases, said Carl Lantz, head of interest-rate strategy in New York at Credit Suisse Group AG. A coupling of the moves -- which could come in the first quarter of 2014 -- would help contain upward pressure on bond yields resulting from a pullback in quantitative easing, he said.
Minneapolis Fed President Narayana Kocherlakota backed a lower rate in a Nov. 12 speech in St. Paul, Minnesota, saying it would provide more monetary stimulus to the economy.
Yellen is committed to promoting strong growth and won’t remove stimulus too soon, even as the Fed’s bond buying comes to a close, she said Nov. 14. “The message we want to send is that we will do what is in our power to assure a robust recovery in the context of price stability.”