A tightening of the Federal Reserve’s ultra-easy monetary policy is drawing nearer, but that doesn’t mean it is close.
At their April 26-27 Federal Open Market Committee (FOMC) meeting, Fed policymakers had an extensive discussion of how to "exit" eventually from a policy that has kept the federal funds rate near zero for 2-1/2 years and ballooned the central bank’s balance sheet to $2.8 trillion.
But as FOMC minutes stipulate, "The Committee’s decision to discuss the appropriate strategy for normalizing the stance of policy at the current meeting did not mean that the move toward such normalization would necessarily begin soon."
Fed funds futures are not pricing in the initial 25-basis-point rate hike until well into next year, and the Fed has done nothing to disabuse market participants of that sense of timing.
True, Minneapolis Federal Reserve Bank President and FOMC voter Narayana Kocherlakota has called for raising the funds rate by 50 basis points before the end of the year, but only under certain assumptions — that core PCE inflation continues to run at the 1.5% first quarter pace and that the unemployment rate fall to 8-8.5%. If inflation falls, he says the Fed would need to "ease further."
Other voting Fed presidents have been less assertive. Chicago’s Charles Evans says he can’t imagine circumstances that would justify a monetary tightening this year. Not even hawkish Dallas Fed President Richard Fisher sounded eager to start withdrawing monetary stimulus when I interviewed him recently. "I think the question is one of timing. It depends on economic developments. I’m on the hawkish wing, but we have to wait and see what data ensues," he says.
Fisher also cautioned the Fed mustn’t "overreact to inflation."
Similarly, Philadelphia Fed President Charles Plosser, another voting "hawk," has been vague as to when the Fed should start any sort of tightening — beyond saying, "If the economy continues to make progress, then monetary policy will need to exit from its extraordinary accommodation in the not-too-distant future."
"As to when to begin exiting from accommodative policy, I will continue to look at the data on output and employment growth and on inflation and inflation expectations," Plosser says.
There are basically two possible motivations for credit tightening:
- An acceleration of GDP growth accompanied by falling unemployment, and
- An unexpected pick-up in inflation and/or inflation expectations by the Fed.
A third possibility would be a traditional mix of faster growth and increased price pressures.
What we’ve been getting so far, in this subnormal recovery, is sluggish growth, still high unemployment and a rise in inflation that Fed Chairman Ben Bernanke and most of his colleagues regard as "transitory."
The clear preference of the FOMC majority is to keep a high level of monetary accommodation in place to support growth and job creation — so as long as, in their view, inflation remains tame and inflation expectations "well-anchored."
Most policymakers envision — and hope for — a scenario in which inflation pressures hold off long enough to allow them to continue to stimulate growth and reduce resource slack by keeping short-term rates very low and putting downward pressure on longer-term rates via quantitative easing.
Although "QE2" has run its course, there is apt to be no rush to unload the securities in the Fed’s portfolio and thereby reduce bank reserves. Even a "passive" shrinkage of the balance sheet, which would be accomplished by ceasing to reinvest principal payments from its securities holdings, likely will be delayed for some time.
This means that, quantitatively, the Fed will be providing plenty of accommodation well past the end of QE2.
The first tightening step, as the minutes confirm, would be to discontinue reinvestment. About the same time the FOMC probably also would remove from its policy statement its quasi-commitment to keep the funds rate "exceptionally low…for an extended period."
However, officials stress those actions would not necessarily mean that rate hikes would necessarily follow within any certain time frame.
Bernanke defines "extended period" as "a couple of meetings." Others call that a bare minimum. Kocherlakota says markets should not "think for sure that we’re going to tighten after two meetings" once that language is dumped.
It all will depend on how the key indicators behave.
If inflation flares in a more persistent way, the FOMC might feel forced to tighten earlier, even if unemployment remains high, but that is not the hope or expectation.
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).