It’s not getting easier to make monetary policy in an improving but still acutely uncertain economic and financial climate. Things were precarious enough when Federal Reserve Chairman Ben Bernanke merely had a financial crisis and recession to confront. With bond yields spiking, things have gotten even more complicated.
Bernanke and his colleagues were confident they were doing the right thing in expanding credit like never before. After slashing the federal funds rate to near zero in December, the Fed resorted to quantitative easing. Going beyond the provision of liquidity as “lender of last resort,” the Fed aggressively expanded its balance sheet and in turn reserves and the monetary base.
There was seemingly nothing the Fed wasn’t willing to try, no matter how many eyebrows were raised about the propriety of the Fed’s cozy partnership with the Treasury and its “mixing of monetary and fiscal policy” as even some Fed officials alleged.
On March 18, the Fed’s policymaking Federal Open Market Committee (FOMC) went nuclear, unanimously voting to buy up to $300 billion in longer-term Treasury securities by fall. That was only part of a $1.15 trillion expansion in Fed securities purchases that also included agency debt and agency-guaranteed mortgage-backed securities.
When the FOMC reaffirmed plans to buy up to $1.75 trillion in securities at its April meeting, minutes showed “some members noted that a further increase in the total amount of purchases might well be warranted.” Meanwhile, the Fed was cranking up the Term Asset-Backed Securities Loan Facility (TALF), a Treasury capitalized program intended to finance private purchases of up to $1 trillion asset-backed securities.
The Fed made no secret of its aim: to hold down longer-term interest rates. Even within the Fed, there were voices of concern. Noting that the Treasury would be issuing over $1 trillion in net new debt by the end of October, Dallas Fed President Richard Fisher said the Fed “can ill afford to be perceived as monetizing that debt, lest we come to be viewed as an agent of, rather than an independent guardian against, future inflation and drive real interest rates higher.”
But the FOMC majority felt justified. The economy was weak and inflation expectations were said to be “well-anchored.” And so, while Bernanke and others uttered reassuring words about developing an “exit strategy” to maintain price stability, the monetary expansion continued.
True, parts of the balance sheet were shrinking as demand for earlier short-term credit programs diminished. However, that shrinkage was offset by the augmentation of longer-term assets.
The problem is, someone forgot to tell bond and foreign exchange markets to behave. The Fed would like to have kept on “printing money,” as Bernanke called what the Fed was doing in a March TV appearance, while bond yields stayed at benign levels. But that scenario was too good to be true.
With the federal deficit projected at $1.8 trillion this year, supplemented by super-charged monetary stimulus, with the dollar losing its safe haven charm, with the Chinese publicly fretting about the value of their Treasury holdings and with the economy showing signs of stabilization, it would have been astonishing if bond yields had not spiked. As of June 1, the yield on the 10-year Treasury note has risen more than a full percentage point since mid-March to 3.7%.
Despite Bernanke’s assurances that the Fed will “unwind” its credit easing in a “timely” way to contain inflation, there were more and more doubters, including some Fed officials.
The mainstream view is that inflation will hold still long enough for the Fed to achieve recovery and start firming policy because of “slack” in the economy, notably an unemployment rate which the Fed projects as high as 9.6% this year and into 2010.
Not so fast, cautions Philadelphia Fed President Charles Plosser.
The crisis may have lowered the economy’s growth potential, thereby narrowing the “output gap”— the difference between actual and potential growth — and reducing the amount of resource “slack.” “If so, the economy may be at greater risk of inflation than the conventional wisdom indicates,” Plosser warned. He’s not the only one who fears the Fed has less time to head off inflation.
But Fed Vice Chairman Donald Kohn probably spoke for most when he said “the economy is only now beginning to show signs that it might be stabilizing, and the upturn, when it begins, is likely to be gradual amid the balance sheet repair of financial intermediaries and households,” adding “it probably will be some time” before the FOMC will need to raise rates. Others think the Fed needs to become even more stimulative, if possible.
Whatever their stripe, policymakers will be confronted with tough choices if bond yields continue higher. If the cause is optimism about the economy that would be understandable, even desirable. But if rates are climbing because of long-term inflation worries, deficit financing fears and concerns about the dollar, then plowing ahead with even more securities purchases could be self-defeating. The Fed may even need to rethink the timing and pace of “unwinding.” It’s too soon to be sure, but the market might just be telling the Fed it needs to execute its “exit strategy” sooner than planned.
Steve Beckner is senior correspondent for Market News International, sponsor of the Web site “The Beckner Report.” He is the author of “Back From The Brink: The Greenspan Years” (Wiley).