A decision by the Federal Reserve to expand its bond buying next week is likely to prompt policy makers to rewrite their 18-month-old blueprint for an exit from record monetary stimulus.
Under the exit strategy, the Fed would start selling bonds in mid-2015 in a bid to return its holdings to pre-crisis proportions in two to three years. An accelerated buildup of assets would also mean a faster pace of sales when the time comes to exit -- increasing the risk that a jump in interest rates would crush the economic recovery.
“There is certainly an issue about unwinding the balance sheet” in a way that “is effective and continues to support the recovery without creating inflation,” St. Louis Fed Bank President James Bullard said in an interview in October. The central bank might have to “revisit” the 2011 strategy, he added.
The Fed is already buying $40 billion a month in mortgage- backed securities to boost the economy, and policy makers meeting Dec. 11-12 will consider whether to purchase more assets. John Williams, president of the San Francisco Fed, has proposed adding $45 billion of Treasury securities a month.
The bigger the balance sheet, “the riskier the exit becomes,” Richmond Fed President Jeffrey Lacker said during a Nov. 20 speech in New York. “That is something we need to think carefully about.”
Krishna Memani, director of fixed income at OppenheimerFunds Inc., said a too-rapid sale of assets risks disrupting the $5.2 trillion market for agency mortgage debt.
“They have to find ways of unwinding the balance sheet without dumping all of it in the marketplace,” said Memani, who oversees a bond portfolio of about $70 billion, including about $6 billion of mortgage-backed securities.
The central bank has been extending the maturities of its assets with Operation Twist, a program to replace $667 billion of short-term debt with the same amount of longer-term bonds that expires this month.
A decision to expand purchases could push the total assets to $4 trillion by the end of 2013, said Michael Hanson, a senior U.S. economist at Bank of America Corp. Total assets stand at $2.86 trillion, up from $869 billion at the end of June 2007.
“The more they add to the balance sheet, the longer it will take to normalize,” said Hanson, who worked on designing tools that will be used in the Fed’s exit strategy as an economist in the monetary affairs division at the Board of Governors in 2009.
Fed Faces Explaining Billion-Dollar Losses in QE Exit Stress
Federal Reserve Chairman Ben S. Bernanke’s efforts to rescue the economy could result in more than a half trillion dollars of paper losses on the central bank’s books if interest rates rise abruptly from recent levels.
That sum is the difference between the value of securities in the Fed’s portfolio on Dec. 31 and what they may fetch in three years, according to data compiled by MSCI Inc. (MSCI) of New York for Bloomberg News. MSCI applied scenarios devised by the Fed itself for stress-testing the nation’s 19 largest banks.
MSCI sees the market value of Fed holdings shrinking by $547 billion over three years under an adverse scenario that includes an economic contraction and rising inflation. MSCI puts the Fed’s mark-to-market loss at less than half that, or $216 billion, if the economy performs in line with consensus forecasts of gradually rising growth, inflation and interest rates.
The potential losses are unprecedented in the Fed’s 100- year history. Bernanke began describing in detail the risk of lower payments to taxpayers for the first time today in his monetary policy testimony before the Senate Banking Committee saying that “remittances to the Treasury could be quite low for a time” if interest rates “were to rise quickly.” Bernanke didn’t describe the overall interest-rate risk to the portfolio or potential mark-to-market losses. He said the Fed is “confident” it has tools to tighten monetary policy.
“You can easily imagine a naive congressional response, which is ‘Where did the money go?’ ” said Sarah Binder, a senior fellow at the Brookings Institution who researches the relationship between the Fed and Congress. “Even if there’s a perfectly logical explanation and the normalization of the balance sheet is a good thing in the long term, the headlines will probably generate congressional scrutiny,” said Binder. “That’s never a good thing from the Fed’s perspective.”
The risk of mark-to-market losses under some scenarios is the price of Bernanke’s battle to overcome the deepest recession since the Great Depression as the Fed embarked on three rounds of so-called quantitative easing. The benefit is more jobs and higher growth, Fed officials say.
“To the extent that monetary policy promotes growth and job creation, the resulting reduction in the federal deficit would dwarf any variation in the Fed’s remittances to the Treasury,” Bernanke said in today’s testimony.
Several Federal Reserve policy makers said the central bank should be ready to vary the pace of their $85 billion in monthly bond purchases amid a debate over the risks and benefits of further quantitative easing.
The officials “emphasized that the committee should be prepared to vary the pace of asset purchases, either in response to changes in the economic outlook or as its evaluation of the efficacy and costs of such purchases evolved,” according to the minutes of the Federal Open Market Committee’s Jan. 29-30 meeting released today in Washington.
The minutes showed policy makers were divided about the strategy behind Chairman Ben S. Bernanke’s program of buying bonds until there is “substantial” improvement in a U.S. labor market burdened with 7.9 percent unemployment, with some saying an earlier end to purchases might be needed, and others warning against a premature withdrawal of stimulus.
“They’re changing the debate toward when to scale it down rather than debating the point where it suddenly ends,” said Jim O’Sullivan, chief U.S. economist at High Frequency Economics in Valhalla, New York. “With the economy looking more solid than they feared a few months ago, financial sector risks take on more importance.”
At their December meeting, Fed officials debated the date for ending their bond purchases, with officials “approximately evenly divided” between those favoring mid-2013 and those favoring a later end, according to minutes from the meeting. Today’s minutes didn’t indicate a discussion of dates.
Federal Reserve Chairman Ben S. Bernanke says the end of the central bank’s bond buying won’t constitute a move toward tighter policy. He may have a tough time convincing stock and bond investors that’s true.
The Fed is acquiring $85 billion of securities each month, and policy makers are grappling with how to condition markets not to interpret a stop in those purchases as a prelude to the exit from easy credit. Bernanke said Dec. 12 in Washington that he “would emphasize” the end won’t be “a turn to tighter policy.”
If the Fed fails, interest rates may climb prematurely, as traders arrange positions for the withdrawal of unprecedented monetary stimulus, according to Dean Maki, chief U.S. economist at Barclays Plc in New York. The Fed has kept its benchmark federal funds rate near zero for more than four years and swelled its balance sheet to a record of more than $3 trillion through three asset-purchase programs.
“There is a risk the markets get ahead of the Fed,” said Maki, a former Fed board economist. “It will be tricky for the Fed to signal it’s going to stop buying without signaling that tightening is imminent.”
Ending the Fed’s third round of so-called quantitative easing carries greater significance than completion of the previous two because those were introduced with defined amounts and durations.
For QE3, the Federal Open Market Committee in September announced purchases of $40 billion a month in mortgage-backed securities, leaving the program open-ended until the labor market improves “substantially.” In December, the FOMC added $45 billion of monthly Treasury purchases.
Marilyn Cohen, founder of Envision Capital Management Inc. in Los Angeles, said she doesn’t think the Fed will be able to convince traders that interest rates aren’t going up when the central bank stops buying bonds. Cohen said she’s already lowered the interest-rate sensitivity of her $325 million portfolio in preparation.
“The markets are on edge; and any hint that things are changing, and we will see the repercussions,” Cohen said. “I’ve been in this business since 1979 -- I’m one of the old dinosaurs -- and I cannot remember when there was such a chorus in the investment landscape that all are calling for higher rates.”
Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co.; Jim Rogers, chairman of Rogers Holdings; Wells Capital Management Inc. and Goldman Sachs Group Inc. all have voiced concern about long-term bonds.
The Jan. 3 release of the minutes from the FOMC’s Dec. 11-12 meeting illustrates investors’ sensitivity, Cohen said. Central bankers discussed possibly curtailing or halting their asset purchases this year. That surprised analysts and traders, sending the Standard & Poor’s 500 Index down 0.2 percent and pushing up yields on the benchmark 10-year Treasury note 0.07 percentage point that day.
James Bullard, president of the Federal Reserve Bank of St. Louis, says the “communication challenge” the central bank faces with the end of QE3 is comparable to all periods of easing.
“The same thing happens with interest-rate policy; you’re lowering the interest rate, and after a while you decide to quit lowering the interest rate and just hold it steady,” Bullard said in a Feb. 1 interview in Washington. “And at that point, you have to convince markets this is really a lower rate than it used to be.”
The Federal Reserve will keep purchasing securities at the rate of $85 billion a month after the economy paused because of temporary forces including bad weather.
“Growth in economic activity paused in recent months in large part because of weather-related disruptions and other transitory factors,” the Federal Open Market Committee said today at the conclusion of a two-day meeting in Washington. “Household spending and business fixed investment advanced, and the housing sector has shown further improvement.”
Chairman Ben S. Bernanke has unleashed the power of the central bank to buy unlimited amounts of Treasury and mortgage- backed securities in a bid to end a four-year long period of unemployment above 7.5 percent and bolster an economy that shrank 0.1 percent in the fourth quarter.
“There is no hint that they are giving any thought of backing off current policy and their current stance,” said Mark Vitner, senior economist at Wells Fargo Securities LLC in Charlotte, North Carolina. “Growth has slowed and inflation is running below expectations. To the extent the Fed’s decisions are data dependent, all the relevant data suggest they should continue to ease.”
Federal Reserve Chairman Ben S. Bernanke’s latest round of bond buying will reach $1.14 trillion before he ends the program in the first quarter of 2014, according to median estimates in a Bloomberg survey of economists.
Bernanke will push on with purchases of $40 billion a month of mortgage bonds and $45 billion a month of Treasuries, according to the survey of 44 economists, even as some Fed officials warn his unprecedented balance-sheet expansion will impair efforts to tighten policy when necessary.
“To get to the point where Bernanke would be comfortable letting up, you have to have a good solid string of economic reports that you’re just not going to get” this year, said Eric Green, global head of rates and FX research at TD Securities Inc. in New York and a former New York Fed economist.
The Federal Open Market Committee will renew its commitment to asset buying during a two-day meeting that began today, after determining the benefits from the program exceed any risk of inflation or financial instability, according to economists surveyed Jan. 24-25. Bernanke has said the policy will continue until there are “substantial” gains in employment.
Fed officials have a brighter outlook for the economy than many private economists. FOMC participants forecast growth this year ranging from 2.3 percent to 3 percent, while economists in a separate Bloomberg survey have a median estimate of 2 percent.
“The economy is not going to be able to generate growth above 2 percent” as it faces headwinds from federal tax increases and a weak global expansion, Green said.
Fed asset purchases will probably do little to help reduce 7.8 percent unemployment, economists said, with 57 percent of them predicting the program won’t help boost the number of jobs created this year.
Economists who expect gains from so-called quantitative easing say it will account for an increase of 250,000 jobs during 2013. Last year, the economy added 1.8 million jobs.
Employers probably hired 160,000 workers in January, after a 155,000 increase in December, based on Bloomberg News survey of economists before the Labor Department reports the figures on Feb. 1.
In the first round of purchases, begun in 2008, the Fed bought $1.4 trillion of housing debt and $300 billion of Treasuries. In the second round, beginning in November 2010, the Fed bought $600 billion of Treasuries.
Record-low mortgage rates aren’t cheap enough for Federal Reserve Chairman Ben S. Bernanke as he tries to spur economic growth and create jobs.
Policy makers are disappointed that lower yields on mortgage-backed securities haven’t led to more savings on home loans after the Fed expanded its balance sheet to an all-time high of almost $3 trillion through bond purchases. Bernanke this month called the trend “unfortunate,” and the Federal Reserve Bank of New York held a workshop to examine the issue.
The gap between the bond yields and home-loan rates is blunting the economic benefits of the Fed’s record accommodation, New York Fed President William C. Dudley said in a speech in New York this month. Among the reasons for the spread: banks are reluctant to take on the expensive fixed costs of new staff to process the paperwork and tougher capital requirements are making it less attractive to service loans.
“The Fed is pushing really hard to try to get the mortgage rate down,” said Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut. “There just doesn’t seem to be much of an inclination on the part of banks to get out there and beat the bushes.”
Central bankers have been examining how to reduce the spread to increase the impact of their existing stimulus as options for further easing dwindle.
The Fed has kept its benchmark interest rate near zero since 2008. The central bank eased policy this month by saying the rate would stay low “at least as long” as unemployment remains above 6.5 percent and inflation projections are for no more than 2.5 percent.
Chairman Ben S. Bernanke moved the Federal Reserve further into uncharted policy territory in combating joblessness by tying the bank’s interest-rate outlook to unemployment and inflation, while committing to an even faster expansion of the central bank’s balance sheet.
The actions on the eve of the Fed’s centenary year underscore Bernanke’s hallmark commitment to experimentation and forceful action, derived in part from his research showing too little monetary stimulus produced large economic costs for the U.S. in the 1930s and for Japan in the 1990s. He called the current state of the labor market, with unemployment at 7.7 percent, “an enormous waste of human and economic potential” and said the benefits of more bond buying outweigh the potential risks.
“Bernanke is pulling out all the stops to kick this economy back into a higher gear,” said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. “They are buying everything in sight -- Treasuries, mortgage-backed securities -- and will keep rates low until everyone who wants a job has one.”
Bonds fell yesterday on the prospect of higher inflation after policy makers boosted their main stimulus tool by adding $45 billion of monthly Treasury purchases to an existing program to buy $40 billion in mortgage debt a month. That decision puts the Fed’s $2.86 trillion balance sheet on track to reach almost $4 trillion by the end of next year.