Business Outlook: The Fed: A Whole New Playbook for Tightening

Over the past year, the Federal Reserve has committed trillions of dollars to its extraordinary effort to shore up the financial markets and prevent a severe recession from turning into a depression. By all signs, and with help from the stimulus package, it's working. Credit is flowing better, and the economy is growing again. Now comes the hard part: Unconventional easing will require unconventional tightening. The old models don't fit the task, and the consequences of a miscalculation are much greater.

Gone are the days of simply deciding when and how much to raise interest rates. This time the Fed has to wind down more than a half-dozen lending and market support programs. It must drain the nearly $1 trillion in excess reserves it has added to the system or at least neutralize their inflationary potential. And policymakers now have to consider two target rates: the traditional federal funds rate on overnight borrowing between banks and a new rate, the interest the Fed pays banks on any excess funds they hold at the central bank. For all this, the past offers no road map.

Fed watchers have a general idea of what tightening will look like, but the devil is in the details—and especially the timing. The first step: to prepare the markets, via speeches or testimony by Fed Chairman Ben Bernanke and by changes in the policy committee's statement. One of the first major alterations will be in the Fed's commitment since March to keep rates at "exceptionally low levels" for "an extended period." Policymakers left that language intact after its Nov. 3-4 meeting, but at some point they will need more flexibility.

Keep in mind, though, that before starting to tighten, the Fed must stop easing. That will most likely occur when the program to buy $1.45 trillion in mortgage-backed securities and federal agency debt, a process that pumps funds into the system, comes to its expected conclusion by the end of March. Then the Fed can begin to drain the excess.

For this, one tool the Fed plans to use is the sale of certain securities, called reverse repurchase agreements. Banks buy these securities in exchange for their excess cash, taking lendable funds out of the system. These sales will not initially involve raising the Fed's traditional target rate, now set at a range of 0% to 0.25%.

Rate increases will come in conjunction with the Fed's new authority to pay banks interest on their deposits. Manipulating this rate, now set at 0.25%, will make it easier for the Fed to control the main target rate, which could be difficult amid the flood of cash sloshing around. A higher deposit rate gives banks incentive to park their excess funds at the Fed and less incentive to lend them out in the interbank market. In this way, the excess funds actually stay in the system, but their potential to create new money and higher inflation is neutralized.

The real question in all this is the timing, something policymakers are already hotly debating. The doves, who are in no hurry to tighten and are in the majority, point to the enormous slack in the economy, which is putting downward pressure on wages and prices and perpetuating the risk of deflation. The hawks say popular measures of underutilized workers and facilities can give misleading impressions of the amount of slack, as was the case in the 1970s. Plus, they worry that exceptionally easy policy could fuel expectations of higher inflation, which are hard to reverse once they become ingrained in business and consumer behavior.

The timing will boil down to when the Fed thinks the recovery is sustainable. Despite last quarter's solid 3.5% economic growth, clear improvement in the job markets, so crucial to sustainability, is still a ways off. Also, wage growth and inflation continue to slow. In the last two recoveries, the Fed did not begin to lift rates until unemployment had fallen notably.

The Fed's first verbal signal is not expected until the Dec. 15-16 meeting at the earliest, and it may not be until well into 2010 that the Fed will very carefully start to feel its way toward tightening.

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