From the April 01, 2010 issue of Futures Magazine • Subscribe!

Interest rates: When will the Fed tighten?

The Federal Reserve is well along in “normalizing” its lending operations and winding down its assets purchased, but it’s still far from shrinking its balance sheet or otherwise tightening monetary policy.
There has been much focus on the “tools” the Fed is readying to implement its “exit strategy.” Bernanke dwelt on how the Fed intends to eventually tighten credit in Feb. 10 Congressional testimony, but the “when” of tightening was as vague as ever as he presented his semi-annual monetary policy report two weeks later.

True, the Fed has shuttered most of its emergency lending windows and is in the process of closing others. It was scheduled to conclude $1.4 trillion of purchases of agency and agency-guaranteed mortgage backed securities at the end of March. And the Fed hiked its penalty discount rate by 25 basis points on Feb. 19 to widen the spread with the Federal Funds rate back toward normal.

Despite Fed assertions that the action had no monetary policy significance, it was widely interpreted as the beginning of an exit strategy. Markets are increasingly nervous about an eventual shift away from a very accommodative monetary policy that has kept the Federal Funds rate near zero since December 2008 and more than doubled the Fed’s balance sheet to nearly $2.3 trillion.

But the Fed should be taken at its word when it says that the discount rate hike was not a tightening signal and that it intends to keep the funds rate very low “for an extended period.”

Speaking for his Federal Open Market Committee colleagues Feb. 24, Bernanke not only reiterated the “extended period” pledge, he said “the FOMC is going to have to continue to evaluate whether additional stimulus would be necessary.” He downplayed inflation risks, calling unemployment “the biggest problem we have.”

Among voting Fed presidents, Boston’s Eric Rosengren said on March 3 that “the economy is experiencing a slow recovery from a very severe recession, particularly when it comes to jobs” and said very low rates are appropriate. Cleveland’s Sandra Pianalto said the recovery “does not feel much like” one as she emphasized high unemployment and low capacity utilization.

St. Louis’s James Bullard said following the discount rate hike that a funds rate increase is “as far away as it ever was.” Calling expectations of Fed tightening later in 2010 “overblown,” he said markets have priced in “too high a probability of tightening this year.”

The exception has been Kansas City Fed President Thomas Hoenig, who dissented at the Jan. 27 FOMC meeting because he disliked continuing to commit to an “extended period” of low rates. “When you have zero rates that go on indefinitely, you are inviting future problems,” he warned.

The Fed’s most recent Beige Book survey validated the majority view. It found the economy continued to expand through Feb. 22, with nine of 12 districts reporting improved but modest growth. Although the pace of layoffs slowed, hiring plans still remained generally soft. Nor does the FOMC’s latest quarterly, three-year forecast suggest any urgency. Policymakers just slightly upgraded their outlook for growth, jobs and inflation to no more than 3.5% this year. They predicted unemployment will range from 9.5% to 9.7% and core consumer prices will rise just 1.1% to 1.7%.At some point, the Fed will begin tightening. In the past, that has meant raising the Federal Funds rate. This time, it will mean not just raising the cost of money but also reducing its quantity.

The Fed has made clear the rate of interest it pays on excess reserves (IOER) will play a lead role when the time comes. The Fed hopes raising that rate will pull up the funds rate and other rates. With volume in the funds market having plunged relative to that of excess reserves, the effective funds rate has traded persistently below target.

So the Fed is considering using the IOER as its new policy instrument for awhile. But no final decision has been made. Minutes of the Jan. 26-27 FOMC meeting show a majority thought the Fed would likely need to reduce reserves before raising the funds rate or the IOER. So the Fed is readying other tools.
It has tested reverse repurchase agreements and plans to extend their use to government sponsored enterprises, which can’t earn interest on reserves. Also in the works is a new term deposit facility, which will allow banks to convert their reserve holdings into a kind of CD.

Those tools “would together allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quite quickly,” Bernanke testified.

The Fed also can reduce reserves more permanently by selling assets, but that seems likely to come only later. While it will be interesting to watch reserve balances from week to week, it is doubtful the Fed will reduce reserves ahead of actual rate hikes without clearly communicating its intentions to start tightening.

We would probably first see a change in Fed rhetoric, including an alteration of the “extended period” boilerplate.Meanwhile, expect further incremental discount rate hikes. Even after it nudges up policy rates, the Fed will remain lax, but that first baby step will be a big deal.

Steve Beckner is senior correspondent for Market News International and is regularly heard on NPR. He is the author of “Back from the Brink: The Greenspan Years” (Wiley).

About the Author
Steven K. Beckner

Steve Beckner is senior correspondent for Market News International. He is heard regularly on National Public Radio and is the author of "Back From The Brink: The Greenspan Years" (Wiley).

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