From the April 01, 2011 issue of Futures Magazine • Subscribe!

Accommodative policy exit still on hold

imageThe 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.

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