Why a Fed Rate Hike May Be Delayed

None of the controversial budget-cutting proposals put forth by Paul Ryan have become law. Nor has the federal budget deficit shrunk by as much as a penny. Yet Ryan's rhetoric has already forced President Barack Obama to respond with his own budget-taming plans. In the process, Ryan is also changing the way the market thinks about the Federal Reserve's next move, and that says something about the dilemma central bank Chairman Ben Bernanke faces.

A month ago, before the budget austerity debate started in earnest, traders in the federal fund futures market in Chicago saw a better than 50/50 chance that the Fed would raise interest rates at or before its meeting on Jan. 25, 2012. The thinking was that Bernanke would have to tap on the brakes as inflation reappeared, gross domestic product headed for nearly a 4 percent expansion in 2012, and cheap money from the Fed flooded the world. It would be time to start taking away the punch bowl.

Now the traders have lowered the odds of a January rate hike from 50 percent to something more like 30 percent. The Ryan effect is partly responsible. The chances of an agreement to slash cumulative budget deficits by about $4 trillion over roughly the next decade have risen, according to members of both parties.

None of the political sausage-making that would go into a historic budget bill technically has anything to do with Bernanke: It's his job to keep inflation under control and use interest rates to manage growth, not to streamline Medicare and Medicaid. Yet government budgets affect the decisions of central banks the world over. As former Fed Governor Laurence H. Meyer puts it, "Monetary policy should always offset what fiscal policy does" to the economy. Bernanke "would never say that, but that is the case," says Meyer, now vice-chairman of St. Louis-based Macroeconomic Advisers.

To reduce the budget deficit, Obama and Congress will have to agree on government spending reductions and tax increases that will slow down the economy. A long-term budget agreement would trim GDP growth by a quarter- to a half-percentage point a year, according to a scenario worked out by economic consultants IHS (IHS). The Fed probably would try to counter the dampening effect of an ever-tighter budget by raising rates more slowly than it otherwise would, says IHS Chief Economist Nariman Behravesh. Says Mohamed El-Erian, chief executive officer of Pacific Investment Management, which runs the world's biggest bond fund: "The more fiscal austerity you get, the more likely that the Fed will stay on hold for longer."

Many others in the bond market share El-Erian's view. If a budget deal slows growth and delays a Fed rate hike, then the value of the current crop of Treasuries should increase and yields decline. Sure enough, yields on 10-year securities plunged to their lowest level in almost a month recently. The yield on 10-year notes was 3.35 percent on Apr. 27. That's more than a half-percentage point below the average yield of about 4 percent during the past decade, based on data compiled by Bloomberg.

Bernanke has another reason not to jack up rates too hastily. Last December, Obama reached a compromise with the GOP to lower payroll taxes and give businesses a tax break on their capital outlays. Those measures are scheduled to expire at the end of 2011, and their absence will help slow GDP growth next year by about 1 percentage point, says Mark M. Zandi, chief economist at Moody's Analytics (MCO).

The impact on GDP of any budget pact would be on top of that. Bernanke told reporters at his first full-fledged press conference on Apr. 27 that tackling the federal debt is a "top priority." He added that the Fed would try to counteract any big short-term hit to growth that might result if a budget deal is struck.

One piece of Fed policy will probably change in the coming months, whatever the fate of the austerity legislation. To keep the economy flush with money and make lending easier, the Fed has been buying $600 billion in Treasury debt from bond dealers since November. Bernanke made it clear that the central bank would wind up that program by the end of June and was not likely to follow it with another one. The Fed will then have to decide whether it should allow its swollen balance sheet to shrink. The way to do that is by not reinvesting in Treasuries the proceeds of any maturing debt it purchased in the $600 billion program and before.

Most of the 50 analysts in a Bloomberg News survey in March said they expect the Fed to keep its bond portfolio stable for some time after the purchase program ends. The Fed may even delay a decision on its balance sheet into next year if Obama and Congress tighten fiscal policy sooner and more sharply than the central bank already anticipates, says Roberto Perli, managing director at International Strategy & Investment in Washington and a former Fed official. A major budget deal will not mean cheap money forever. Yet it will change Fed strategy on how to keep the recovery going.

The bottom line: The drive to reduce the budget deficit has made it less likely the Fed will raise rates before January 2012.

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