Federal Reserve Chairman Ben Bernanke is preparing for a most sensitive task: telling jittery investors who have grown accustomed to the U.S. central bank’s ultra-easy monetary policies that things will eventually have to change.
Bernanke appears committed to the Fed’s bond-buying stimulus right now. But the unprecedented communications challenge of laying groundwork for a shift in policy, while still assuring investors that rates will continue to stay low, could come in just a few months if the U.S. recovery continues apace.
In speeches around the country, other Fed officials have already begun discussing the eventual reversal of some of the most supportive policies the United States has ever seen.
And investors are increasingly parsing minutes of the central bank’s policy meetings for hints on just how long the $85 billion in monthly asset purchases will last.
Ideally, Bernanke— who is set to testify to Congress on Tuesday and Wednesday, and speak in San Francisco on Friday— would need to say little in the months ahead. The improving economy should do the lion’s share of the work in preparing markets, paving the way for a predictable and smooth turn in policy.
But Fed officials worry that even a small tapering of their bond-buying program could ricochet through financial markets, sharply raising longer-term borrowing costs and choking off the economic growth they have worked so hard to foster.
“We are in a world where, when the Fed starts moving toward a less-stimulative policy stance, at some point the markets are going to say ‘Oh my goodness,'” said Nathan Sheets, global head of international economics at Citigroup and a former economist for the Fed’s policy-setting committee.
Last week, the central bank got a taste of just how abruptly investors can react to a whiff of policy change.
Minutes from the Fed’s January meeting showed that a number of policymakers thought the asset purchases “might well” have to slow or stop before the jobs market improved as much as desired.
Even though “several others” warned of curtailing the program too soon, that sentence, hedged as it was, sent the dollar to a four-week high against the euro and fueled the sharpest stocks selloff in three months.
Dallas Fed President Richard Fisher told Reuters the following day that the reaction was a worrisome sign of “a market that’s hooked on the drug” of easy Fed money.
Beginning Of The End?
In the past few weeks, several Fed officials have begun to set the stage for weaning the addict off the drug, expressing a preference for tapering rather than sharply ending the bond-buying program as the jobs outlook improves.
“I think that talk of tapering is almost the beginning of tapering, the market has become so well accustomed to the Fed being there and changing the supply and demand dynamics,” said Tom Simons, an economist at Jefferies.
“Fed officials are always pushing the notion that communications are the best policy tool,” he added. “So if they can communicate that the market should be prepared for a tapering and then there is a tapering and then it ends, that’s the most gradual way the program could end.”
The Fed’s stated plan is to end its bond buying once a “substantial improvement” in the labor market outlook is achieved, but to keep interest rates near zero until unemployment falls to at least 6.5 percent, from 7.9 percent last month, as long as inflation remains contained.
Further down the road, it would work on gradually unloading the assets on its balance sheet that are now valued at some $3 trillion. That job would very likely fall to Bernanke’s successor because the chairman is not expected to stay on after his term expires in January 2014.
Bernanke is not expected to change his dovish tone this week, despite mounting concerns over the size of the balance sheet. But his role over the next year, or longer if he stays in office, will be critical as he begins to navigate a long and delicate process of policy tightening, assuming the recovery takes hold as Fed officials hope.
There are a lot of unknowns, especially compared with the beginning of the last major cycle in which the Fed tightened monetary policy in 2004, when the only policy lever was overnight interest rates.
This time the Fed has the size and makeup of its balance sheet, stuffed not only with Treasuries but also mortgage-backed securities, and all sorts of new communications tools, like the economic thresholds it has set to signal when the time is approaching to raise interest rates.
“Managing the public’s expectations of monetary policy is a difficult task, especially when the policy is far from what the central bank has implemented in the past,” Philadelphia Fed President Charles Plosser said in a recent speech.
“This opens the door for the public to misunderstand the message the central bank is sending,” he said. Plosser and Fisher are both critics of the Fed’s bond-buying plans.
‘Markets Tend To Overreact’
There could be trouble if investors misinterpret when the asset purchase program will end. An abrupt selloff in bonds for example could send longer-term rates soaring, derailing the gradual reversal for which the Fed hopes.
Yields on 10-year Treasury bonds have drifted higher this year, due in part to signals that a policy change could come as early as mid-year, and to signs the economy is strengthening.
“Absent some dramatic change in the economic landscape, when the time comes to normalize it’s likely to be accompanied by a very gradual adjustment in the Fed balance sheet,” said Jeffrey Fuhrer, senior policy adviser at the dovish-leaning Boston Federal Reserve Bank.
“If those things are right then you’d probably expect some relatively modest effect on long-term interest rates,” he said. “But as a general rule markets tend to overreact a little bit.”
A series of economic false starts in each of the last few years has sowed worries about tightening too quickly. Most Wall Street economists expect the Fed to slow its asset purchases only after the jobs market has established a stronger footing, in the first quarter of next year.
But the policy turn could come even quicker if the growing cadre of Fed officials worried about the eventual downside of the program win more converts.
And while Bernanke has said the Fed will weigh the costs and benefits of the current quantitative easing, known as QE3 because it is the third such program since the recession, he reportedly brushed off the risks of asset bubbles in a private meeting earlier this month with bond dealers and investors.
In his last public speech, in January, he said it was still “kind of early” in QE3 to expect to see a decline in unemployment, suggesting Bernanke sees the program continuing for some time yet.
“The bottom line is the economy is on heroin today and we will at one time move to a diluted form of heroin,” said Robert Lutts, chief investment officer at Cabot Money Management in Salem, Massachusetts. “If they tell me they are taking the heroin away, we are going to have a hiccup.” (Additional reporting by Chuck Mikolajczak; Editing by Maureen Bavdek)