Federal Reserve hopes clear exit strategy will boost market confidence
Federal Reserve hopes clear exit strategy will boost market
confidence
By Neil Irwin
Washington Post Staff Writer
Tuesday, February 9, 2010
When you've flooded the economy with trillions of dollars,
mopping up is no easy task.
That's the reality the Federal Reserve is confronting as it
starts to explain how it will undo the aggressive growth-supporting
steps that were put in place when the economy was in its deep dive
-- and begins to be clearer about when that may happen.
But it is a fraught exercise. Federal Reserve leaders and
private economists expect the jobless rate to remain high for
years, despite a dip in the unemployment rate to 9.7 percent in
January, and the Fed could make the situation worse if it moves too
abruptly. In the meantime, financial markets have shown new signs
of fragility, swooning in the past three weeks, including a 1
percent drop in the stock market Monday that drove the
Dow Jones industrial average to close under 10,000 for the
first time in three months.
Fed Chairman Ben S.
Bernanke is betting that if the central bank is open about how
it will phase out its expansive initiatives to prop up the economy,
it will provide faith that the Fed will not allow inflation to
flare down the road. That in turn would help keep long-term
interest rates low and could allow the Fed to keep the short-term
rates it controls at ultra-low levels for longer.
"You're trying to inspire confidence that you know what you're
doing, which can help put the brakes on any incipient inflation
without damaging the recovery," said Karen Dynan, a Fed economist
until last year who now co-directs the Brookings Institution's
economic studies program.
But that strategy comes with risks. Most notably, investors may
interpret the talk about reducing the money supply as a sign that
those steps are imminent. That could prompt interest rates to rise
sooner than the Fed would like, which could slow the economic
recovery or even stop it.
Bernanke is scheduled to testify before the House Financial
Services Committee on Wednesday about unwinding Fed actions and
will probably elaborate on those plans later in the month with his
semiannual testimony on Capitol Hill about monetary policy.
Once the time comes, the Fed is likely to sop up cash from the
economy by increasing the interest paid on excess bank reserves.
Banks often park money they aren't otherwise using -- for instance,
lending to borrowers -- at the Fed and are currently paid 0.25
percent interest on those reserves. If inflation became a threat,
the Fed could raise the interest rate, giving banks an incentive to
park even more cash rather than lending it.
The Fed has been able to pay interest on reserves only since the
power was included as a little-noticed part of the law that created
the $700 billion federal bailout, known as the Troubled Assets
Relief Program, in October 2008. But now, Fed officials view this
authority as a key element in the central bank's tool kit for
managing the economy. This power could even eclipse the approach
the Fed has traditionally used to influence the economy: setting a
target for the "federal funds rate" at which banks lend to one
another.
"Interest on reserves is the workhorse . . . and is intended to
be the main tool" in the Fed's exit strategy, James Bullard,
president of the Federal Reserve Bank of St. Louis, said in an
interview Monday. That, he added, has created significant
discussion within the Fed about how to make policy in the months
and years ahead.
"The old regime was it was always about the fed funds rate,"
Bullard said. He added: "You had a long history of what the impact
on the economy was of a change in the rate. We don't have that now,
and it doesn't look like we'll really be back in that scenario
anytime very soon."
The Federal Reserve
Bank of New York, which executes the central bank's monetary
policy by buying and selling securities, has been experimenting
with other tools that might allow it to drain the money supply,
including "term deposits." These would essentially give banks
incentive to deposit money at the Fed for a set period of time. The
Fed is also testing reverse repurchase agreements, which would
allow the central bank to temporarily swap assets on its balance
sheets for cash, thus pulling that cash out of the financial
system.
As of Feb. 1, the Fed ended several of its more unconventional
lending programs that were started during the depths of the
financial crisis. And Fed leaders have said it will cease purchases
of $1.25 trillion in mortgage-backed securities by the end of
March. A knottier question is when it might sell some of those
securities on the open market, as opposed to letting them reach
maturity over many years.
Selling these securities would pull money out of the economy and
shrink the Fed's $2.2 trillion balance sheet, helping to avoid
inflation and getting the Fed out of the business of subsidizing
mortgages. But selling the assets probably would drive up mortgage
rates, damaging a housing sector whose recovery is slow and
fragile.
So far, the Fed has convinced markets that the "how" of
unwinding support for the economy is separate from the "when." As
for when the rate increases will begin, that will depend on how the
economy is doing and whether inflation expectations rise. If the
recovery fizzles, the central bank would wait longer. If there is a
strong burst of growth, rates would increase sooner. Similarly, the
Fed would probably raise rates sooner and more aggressively if
investors began to expect a burst of inflation.
At its policymaking meeting in late January, the Fed said it is
likely to keep interest rates "exceptionally low" for "an extended
period," repeating language it has used for more than a year. While
Fed policymakers have differing views on how long an extended
period would be, William C. Dudley, president of the Federal
Reserve Bank of New York, said last week that it means rates will
stay very low for at least six more months.
The financial markets will be closely watching Bernanke testify
Wednesday before the House Financial Services Committee. After all,
the key to Bernanke's strategy is winning is the confidence of
market participants in the Fed ability to drain cash from the
system.
"I think the markets would like to have a bit more transparency
on the exit strategy plans," said Kurt Karl, chief U.S. economist
at Swiss Re. "It's probably the right time to provide more detail.
As I understand it, the chairman will provide quite a bit of
detail, though perhaps not as much as the market wants."
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