Now that the economy is limping out of recession and the financial system seems to be stabilizing, the inevitable question is, when will the Federal Reserve start to tighten credit?
The Fed’s policymaking Federal Open Market Committee has often stated its expectation that the Federal funds rate, targeted at 0-0.25% since last December, will be kept “exceptionally low...for an extended period.” The crucial question is, just how far will this “extended period” extend? The other imponderable is, at what pace will the Fed tighten once it gets started?
There is a body of thought, based on woeful experience, that the Fed should be preemptive. If it waits until the economy is in full-blown recovery, some argue, then it’s too late to forestall higher inflation or some sort of asset bubble. That would seem to be the lesson of the Fed’s last extended period of easy money in 2003-04, which helped cause the housing boom-bust and financial crisis.
But preemption does not seem to be the prevailing mood. Ben Bernanke has made clear the Fed will not start tightening until recovery is established and gaining strength. His view seems to be widely shared, although there are divergences of opinion, which could grow as a recovery proceeds.
Atlanta Federal Reserve Bank President Dennis Lockhart, an FOMC voter, said in late August that it would be advisable to be patient. “It’s too early to be contemplating a rise in the Federal funds target.”
But Richmond Fed President Jeffrey Lacker, also an FOMC voter, was less reticent about early tightening. “I am certainly aware of the danger of aborting a weak, uneven recovery if we tighten too soon. But there can be a strong temptation to hesitate when emerging from a recession, awaiting conclusive signs of robust growth.”
“Keeping inflation well-contained may require action before a vigorous recovery has had time to establish itself,” said Lacker. “We’re going to have to move before the unemployment rate falls a lot.”
Splitting the difference, St. Louis Fed President James Bullard, one of next year’s voters, told me rate hikes may be “quite a ways away,” but said the FOMC must be more prepared than earlier in the decade to “renormalize interest rates.” However, San Francisco Fed President Janet Yellen said in July that the funds rate may need to stay at zero “for several years.”
The cautious consensus is borne of a feeling that this has been a peculiarly severe economic situation that has yet to be resolved, and risks remain. One is commercial real estate. Another, ironically, is that in the name of fiscal stimulus unprecedented federal borrowing to finance deficits estimated at a cumulative $9 trillion over 10 years, could drive up long-term interest rates and stunt business and household spending.
Growth is expected to be too sluggish to bring the unemployment rate down rapidly. And the majority view, from which some dissent, is that resource “slack” will keep inflation safely subdued for the next few years.
As for the pace of tightening, there is some sentiment for moving rates up swiftly once it starts. But others will be inclined to move incrementally, though perhaps not at quite so “measured” a pace as in 2004-06, when the FOMC raised the funds rate by 25 basis points at 17 consecutive meetings.
If and when the economy gains strength, the FOMC must decide when and by how much to move, hopefully without undue political pressure. Threats to the Fed’s independence could fuel fears of debt monetization, increasing inflation expectations and counterproductively pushing up long rates.
The instrumentalities of tightening will be different this time. In past credit cycles, the Fed has been able to push up the funds rate and in turn other rates pretty much at will to regulate credit flows. It won’t be quite so simple this time, because the Fed’s massive lending and asset purchases have more than doubled its balance sheet to over $2 trillion. Commensurate reserve growth has ballooned the monetary base, creating a looming inflation threat should increased lending expand the broader money supply.
In that environment, simply raising the funds rate target would likely be thwarted by the sheer volume of reserves. There would be a tendency for the effective funds rate to trade below target but for one thing: the Fed’s ability to pay interest on reserves. It hopes that tool will incentivize banks to keep holding large amounts of excess reserves at the Fed, rather than lending them into the economy.
By paying interest on reserves and theoretically setting a floor under the funds rate, the Fed can tighten credit by raising the funds rate and, at the same time, discourage a certain amount of lending, even while continuing to maintain a large balance sheet.
But, as Bullard observes, “we can’t just rely on interest on reserves to do everything for us going forward — not with the size of the balance sheet.” Paying interest on all those reserves will become more and more costly as the Fed ratchets rates up, and Congress may not like massive transfers of funds to the banks.
Nor will the Fed be able to just sit back and wait for assets to mature and run off naturally. The Fed likely will have to sell assets to absorb reserves, shrink the monetary base and avoid inflation. There’s no question the Fed has the tools for the job. Finding the will and wisdom to use them appropriately will be the real challenge.
Steve Beckner is senior correspondent for Market News International, which sponsors his Web site “The Beckner Report.” He is regularly heard on NPR and is the author of “Back From The Brink: The Greenspan Years” (Wiley).