Fed faces key policy decisions

Fed faces key policy decisions
By Krishna Guha in Washington
Copyright The Financial Times Limited 2009
Published: June 14 2009 20:14 | Last updated: June 15 2009 03:00
http://www.ft.com/cms/s/0/7ed3abf8-590c-11de-80b3-00144feabdc0.html


The sharp increase in both US bond yields and mortgage rates presents the ­Federal Reserve with two key decisions next week: whether to increase its ­purchases of Treasuries and whether to push back against expectations of early interest rate rises.

With the US central bank unlikely to authorise large increases in Treasury purchases, the debate is between stopping at the declared $300bn, or increasing this total modestly to enable a gradual phase-out.

Some Fed officials think there could be merit in redirecting some money slated for purchases of mortgage-related securities towards Treasury purchases – giving it more latitude in this market without increasing overall purchases.

Meanwhile, the Fed is likely to reiterate that it expects to keep rates near zero for an “extended period”, challenging market expectations of early tightening. But it will also repeat – and might sharpen – the message that it is not tied to any course of action.

Fed hawks are getting edgy. “As the economy recovers, even at a modest pace, resource demands will begin to increase,” Tom Hoenig, president of the Kansas City Fed, said on June 3. “At this point the current level of monetary accommodation will need to be withdrawn.”

But some Fed officials highlight the low level at which activity is stabilising. “Not enough attention is being paid to how much ground we will need to cover before we return to our pre-recession level of activity,” said Sandra Pianalto, president of the Cleveland Fed, on June 4.

The Fed leadership – which puts considerable weight on spare capacity – almost certainly shares this view. Officials probably do not expect to raise rates late this year or early next, assuming sub-trend growth, projected drag as the fiscal stimulus fades and the phasing out of some financial market programmes first. However, the statement may accommodate some of the hawks’ concerns.

Officials view the policy equivalent to keeping rates on hold as involving a slight increase in Treasury purchases, since the market originally expected this.

However, many think the slight tightening implied by stopping at $300bn might be appropriate. Since the last Fed meeting financial conditions have eased, the risk to growth has abated and the risk that inflation may rise has increased.

As a result, the optimal interest rate will now be higher than in March when purchases were approved. Then, Fed staff estimated the optimal rate to be mimicked through asset purchases was minus 5 per cent. Now, some think it is no lower than minus 3 per cent and could be higher.

On the face of it, that would argue for a reduction in expected purchases. Against this, the Fed never authorised the amount of purchases staff thought equivalent to a policy rate of minus 5 per cent.

Policymakers are not indifferent to the rise in yields and see some threat to housing. But they expect the yields will adjust back down if they do overshoot.

They are, however, concerned about the cliff-edge effect of stopping Treasury purchases, when the $300bn programme is scheduled to lapse in September.

One option is to stretch it out to year end. Another is to add perhaps $100bn, ­possibly from planned purchases of mortgage-backed securities. Mortgage spreads remain moderate, and Fed buying of these securities is likely to slow in coming months in tandem with an expected decline in new issuance.

Some officials have considered merging the different asset purchase buckets into one purchase fund, though this could make Fed buying less predictable.

Further ahead, some are considering whether the Fed could eventually shift from regular purchases of mortgage-related securities to a backstop role, analogous to its commercial paper facility, stepping in only when spreads expand or liquidity thins.