Fed Seen Twisting to Risk Management to Spur U.S. Growth
Federal Reserve officials must choose this week between their best estimates and their worst fears of what will happen to the U.S. economy.
Policy makers will bring new forecasts to their June 19-20 meeting and probably will mark down their April central-tendency estimate for growth of 2.4 percent to 2.9 percent this year. Lurking in the background is the risk of increasing financial stress in Europe and stubbornly high U.S. unemployment that has remained above 8 percent for 40 consecutive months.
All this could prompt them to move away from their outlook for moderate growth and tilt toward a “risk-management” strategy pioneered by former Fed Chairman Alan Greenspan, which puts more emphasis on tracking and containing high-cost threats. Both Janet Yellen, the Fed’s vice chairman, and William C. Dudley, head of the Federal Reserve Bank of New York, used the phrase in the past month.
“What we are hearing from Vice Chairman Yellen and President Dudley, and the minutes of the last meeting, is that there are more risks on the downside,” said Donald Kohn, the former Fed vice chairman who is now a senior fellow at the Brookings Institution. “The ability to combat weakness with interest rates at the zero lower-bound is limited and uncertain. In a situation like this, their reasoning is you might want to buy some insurance.”
That insurance may come in the form of extending Operation Twist -- which JPMorgan Chase & Co. and Jefferies & Co. predict -- or an even more aggressive response if Fed officials see high costs in a slowdown of U.S. growth. The $400 billion program, which was announced in September and ends this month, involves selling short-term debt and buying longer-term bonds.
The Fed has about $190 billion of short-term maturities left to continue Operation Twist for another three months, based on calculations by Nomura Securities International Inc. The firm’s forecast is for no extension at the June meeting, with both Chairman Ben S. Bernanke and the Federal Open Market Committee probably indicating they could take additional easing steps, such as outright bond purchases, if economic circumstances warrant.
An extension would fit a forecast that says the U.S. economy will avoid a disaster scenario of rising unemployment and rapidly decelerating inflation. The Fed’s decision June 20 at 12:30 p.m. New York time could be more aggressive than investors expect if policy makers decide their confidence in their own forecasts is low and want to do something extra to lean against a worst-case scenario, said Vincent Reinhart, chief U.S. economist in New York at Morgan Stanley.
“We put high odds on them acting at the meeting,” said Reinhart, who was the head of the Fed board’s Division of Monetary Affairs, which develops policy strategy, under chairmen Greenspan and Bernanke. “Risk management says that you act in advance of a potential downdraft in activity because that could trigger” a collapse in demand that would be difficult to escape with the main policy rate at zero. The Fed cut the target for the federal funds rate to a record-low range between zero and 0.25 percent in December 2008.
Financial-market indicators are signaling a flight from risk. Yield spreads on the Credit Suisse U.S. Liquid Corporate Index, which tracks almost 1,300 U.S. investment-grade corporate bonds with an average maturity of about 10 years, widened to as much as 1.865 percentage points over Treasuries of similar maturity this month, the highest since January.
Greece’s largest pro-bailout parties, New Democracy and Pasok, won enough seats to forge a parliamentary majority, easing concern the country was headed toward an imminent exit from the euro. Even so, optimism about the election quickly faded as Spain’s 10-year bond yields rose above 7 percent to a euro-era record.
The Standard and Poor’s 500 Index was basically unchanged at 1,343.43 at 11:00 a.m. in New York, while yields on Treasury 30-year bonds fell to the lowest in more than a week. The yield on the benchmark long-term government bond stood at 2.67 percent after reaching 2.65 percent, the lowest since June 8.
In the U.S., payrolls increased by just 69,000 jobs last month, and unemployment rose to 8.2 percent from 8.1 percent in April. Retail sales fell for a second month, with the May total, excluding autos, slumping by the most in two years. Still, few private-sector economists are forecasting another recession. The U.S. will grow between 2 percent and 2.5 percent in each of the remaining three quarters this year, according to the median estimates in a Bloomberg News survey in early June.
Some of the weakness in labor markets could be explained by unseasonably warm weather that boosted hiring earlier this year. Operation Twist has helped increase housing activity, with sales of new and existing homes rising to a 4.96 million seasonally adjusted annual rate in April from 4.51 million a year earlier, based on Bloomberg calculations.
Fed officials probably won’t have complete confidence in a baseline outlook that’s likely to call for continued moderate growth and perhaps even a faster acceleration next year, said Julia Coronado, chief economist for North America at BNP Paribas in New York.
“What the Fed is worried about is that a seasonal slow patch will be converted into something worse because of the uncertainty over Europe and U.S. fiscal policy,” said Coronado, who worked on the Fed board forecasting staff. “The risks are that we will be disappointed on the downside in the U.S. economy again.”
Yellen’s outlook calls for a gradual reduction in the unemployment rate and stable inflation of around 2 percent, she said in a June 6 speech in Boston. Being patient with that forecast may not be desirable, she added.
“Risk-management considerations arising from today’s unusual circumstances strengthen the case for additional accommodation,” she said. “It may well be appropriate to insure against adverse shocks that could push the economy into territory where a self-reinforcing downward spiral of economic weakness would be difficult to arrest.”
Yellen said the FOMC could begin another round of bond purchases or extend its portfolio maturity further if the expansion proceeds at an “insufficient pace.”
Dudley addressed similar concerns in a May 24 speech before the Council on Foreign Relations in New York. Hazards to U.S. growth are “skewed to the downside, reflecting risks posed by developments in Europe and the impending U.S. fiscal cliff,” he said. “The costs associated with such downside outcomes are likely to be considerably higher than the costs of realizing upside surprises.”
The so-called fiscal cliff includes the expiration of income-tax cuts first enacted under President George W. Bush, the end of payroll-tax reductions and automatic decreases in government expenditures, which would trim a combined 3 percentage points from growth next year if allowed to kick in, according to economists surveyed by Bloomberg News at the end of May. Instead, compromises will limit the damage to 0.8 point, sustaining the expansion, the survey showed.
In a 2003 speech that shaped monetary-policy strategy, Greenspan told central bankers in Jackson Hole, Wyoming, that “uncertainty” was the “defining characteristic” of the policy landscape, making risk management a core element of central banking.
“Policy makers need to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path,” he said. Officials “operating under a risk-management paradigm may be led to undertake actions intended to provide some insurance against the emergence of especially adverse outcomes.”
That paradigm is the opposite of a “keep-your-powder-dry” strategy that waits for confirmation from lagging economic data to indicate the economy is turning one way or another, said Joe Gagnon, senior fellow at the Peterson Institute for International Economics in Washington.
He predicts the Fed will extend Operation Twist for another three months. Because risk-management considerations come into play, he said he won’t rule out another round of bond purchases that includes mortgage-backed securities.
“Risk management means your forecast is the most likely outcome, but you shouldn’t just set your policy on that,” said Gagnon, who worked under Greenspan and Bernanke as associate director in the Fed’s Division of International Finance. “If the risk now is a lower outcome on employment or growth, then they need to take that into account by being more stimulative than they otherwise would have been.”
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