The economy, and hence the Federal Reserve, are beset by uncertainty, forcing monetary policymakers to keep their options open. It would take a lot for the Fed to continue quantitative easing beyond the $600 billion in longer-term Treasury securities scheduled for purchase by the end of June, but the Federal Open Market Committee (FOMC) is equally unlikely to start tightening any time soon.
Despite the growth-dampening effect of higher commodity prices, particularly crude oil, most data have been encouraging enough to make Fed officials confident a double-dip recession can be avoided. And deflation fears have receded.
Barring an unforeseen crisis, the FOMC is done with quantitative easing, but it also would take a substantial upside surprise to growth or inflation to get the FOMC to tighten.
Talk of an early end to QE2 seems fanciful. But if real GDP grows 3.4%–3.9% as the FOMC projects, it’s possible that — after the Fed stops expanding the balance sheet — it will resume letting maturing mortgage backed securities run off, thereby allowing some "natural" shrinkage of a balance sheet projected to reach $2.6 trillion by mid-year.
But that step should not be seen as the start of a full-blown exit strategy. It’s hard to imagine the FOMC authorizing more active balance sheet reductions involving outright sale of assets in coming months or to begin raising official short-term rates. There are those who would like to see tightening, but they’re a minority. Chairman Ben Bernanke and others are not convinced it is time to start that process given high unemployment and assorted downside risks.
New York Fed President William Dudley says that rates can remain unusually low for an "extended period," barring significant changes in growth and inflation. "The economy can be allowed to grow rapidly for quite some time before there is a real risk that shrinking slack will result in a rise in underlying inflation," Dudley says.
Bernanke says the Fed will tighten when recovery is "self-sustaining," but predicts it will be several years before unemployment is back to more normal levels and that the recovery truly won’t be established until there has been "a sustained period of stronger job creation." Meanwhile, inflation is "quite low" and apt to stay so.
The Fed’s own beige book survey finds many manufacturers and retailers are passing along higher costs to customers. Nevertheless, the FOMC majority feels it is missing on both sides of its "dual mandate" and hence is justified pursuing a highly accommodative policy and doesn’t want to get ahead of itself.
Although monetary normalization seems far down the road, exit tools are increasingly on policymakers’ minds, if only to reassure markets they are willing and able to tighten when the time comes. Most members lean toward raising the rate of interest paid on excess reserves (the IOER) and, in turn, other short-term interest rates as the first step. They are inclined to delay actively shrinking the balance sheet. But the FOMC likely will leave its options open and tailor its exit strategy to changing circumstances.
Market expectations will play a key role. The FOMC may want to tighten in its usual manner. But if growth accelerates faster than anticipated and/or inflation and inflation expectations move up, it may prefer more aggressive firming.
That could present problems, though. When the FOMC last began raising the funds rate in June 2004, following a year-long stay at 1%, it did so in a slow, "measured pace," taking the funds rate up to 5.25% in 25-basis-point steps at 16 successive meetings. Memories of that tediously predictable approach could condition market reactions. To get a stronger reaction, the FOMC may consider some balance sheet reduction.
A hybrid approach is possible using a combination of the rate and balance sheet channels. Also, the exit strategy may need to change as the Fed finds its way. Communication will be key. To avoid the appearance of being locked into a perpetually incremental tightening pace and leave itself the option of taking larger steps, the FOMC may want to avoid such phraseology as "measured pace."
The FOMC’s longstanding pledge to keep rates "exceptionally low...for an extended period" will have to go at some point. Vice Chairman Janet Yellen indicated that the Fed would have flexibility regarding that guidance.
There are other issues to ponder. Officials have expressed hope that raising the IOER will pull up the funds rate, but they aren’t sure. Because government sponsored enterprises can’t earn interest on reserves, and thus have little incentive to hold them, the gap between the IOER and funds rate could widen. The Fed could conduct policy effectively if the gap is relatively small and steady, but if it becomes large and unpredictable, then that would complicate the New York Fed open market desk’s operations and force it to drain reserves.
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).
