Research & Advice

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The Fed’s Blueprint

Thursday, April 28, 2011

 

  • The FOMC had a schedule meeting yesterday followed by a first-ever post-meeting press conference, thus ushering in a new level of Federal Reserve transparency.

  • A few minor tweeks in the Fed’s post-meeting statement displayed a subtle hint that policymakers are shifting their focus (albeit modestly) from growth to inflation.
  • The FOMC maintains its easy money policy and intends to do so for an “extended period.”

  • Berkshire Money Management (BMM) has an expected blueprint for when, and how, the FOMC will begin to tighten monetary policy.

 

In joining with the ranks of the rate hikers (Australia, Singapore, South Korea, Sweden, Norway, & Poland), recently the European Central Bank became the latest central bank to take up arms against inflation. Yesterday, April 27th, the US’ Federal Open Market Committee (FOMC), the component of the Federal Reserve charged with setting the nation’s open market operations and thus monetary policy, had the opportunity to claim that designation, but the Fed opted to continue an easy money policy for an “extended period”.

Despite the US’ easy money policy, the global rate hike trend has broadened globally, bringing rates closer to the point where they may negatively affect global trade. BMM’s current view, however, is that the global stock market advance will withstand the rate pressures for some time (that’s not to say there won’t be other complications, but this report is meant to address only interest rates). The initial threat to the financial markets has been the surge in pace of change from extremely low levels, primarily among long-term rates. But even with more central banks raising rates, we have yet to see global rate pressure broadly evident among short-term rates and yield curves.

Yesterday, after the FOMC’s meeting, history was made when Fed Governor Ben Bernanke took to the podium to address questions from business journalists. Having come from an era where we attempted to read the tea leaves of the Fed’s potential next steps by discerning the size of then Fed Governor Alan Greenspan’s briefcase (the infamous “briefcase indicator”), we feel that giant steps have been made in regard to Fed transparency.

A few minor tweeks in the Fed’s post-meeting statement displayed a subtle hint that policymakers are shifting their focus (albeit modestly) from growth to inflation. We classify the shift as “modest” because the FOMC does not yet sound overly worried about price instability, calling measures of underlying inflation still “subdued.” (We expect some to take issue with that classification.)

  

Still, there is a lot left to be desired for those seeking perfect clarity. For example, when Bernanke was asked to clarify the FOMC’s use of the phrase “extended period” he admitted that “unfortunately, the reason we use that vaguer terminology is that we don’t know with certainty how quickly a response will be required.”

Even before yesterday’s press conference, Berkshire Money Management believed we had a reasonable blueprint for the Fed’s exit strategy from its easy money policy. Yesterday’s communications offered little in the way of the central bank’s exit strategy, but it also contained nothing to make us believe that our expectations need to be readjusted.

Having a blueprint for the Fed’s actions is important in setting investment policy decisions, so BMM takes notice and calculates potential and likely next steps. The first of these steps will be for the Fed to determine when to halt “QE2” (QE2 is the Fed’s second round of quantitative easing, a program of purchasing $600 billion of Treasuries in support of its dual mandate of maximum employment and price stability). For the last few months we have expected the Fed to complete its asset purchase program by the end of June, as originally scheduled. At its start we acknowledged that there was a small chance that the Fed would taper its purchases, or even extend its purchases at a lesser rate in the second half of the year, as they did with QE1. But that idea was put to rest at the March 15th meeting when the System Open Market Account (SOMA) manager Brian Sack said “that the greater depth and liquidity of the Treasury securities market suggested that it would not be necessary to taper purchases in this market” and almost all meeting participants (including St. Louis Fed President Bullard & Dallas Fed President Fisher) agreed with Sack’s conclusion.

All Fed members acknowledge that any exit strategy is dependent on economic conditions. Interestingly, the FOMC minutes for the March 15th meeting read as if they were coming up with a decision tree when it stated that it was “prudent to consider possible exit strategies for a range of potential economic outcomes.” Of course, at the center of the debate – the most likely selection from the decision tree – is the sustainability of the economic recovery. Bernanke has testified that the Fed has seen “increased evidence that a self-sustaining recovery in consumer and business spending may be taking hold.” But he did add, “until we see a sustained period of stronger period of job creation we cannot consider the recovery to be truly established.”

What does a sustained period of stronger job creation mean? The US economy has created a net 1.5 million nonfarm jobs over the past thirteen months. Our research shows that the Fed would likely need to at least be able to project over the near-term an unemployment rate below eight percent before it would consider raising interest rates. If the rate continues down its present path, we could see eight percent by yearend. The level of the unemployment rate and its rate of change will strongly influence the timing and pace of the Fed’s tightening policy.

The Blueprint

In formulating our blueprint of the Fed’s exit strategy from an easy money policy, we have read speeches and reviewed testimony of numerous Federal Reserve officials. What follows is the blueprint Berkshire Money Management believes is the most probable schedule as well as what tools will be used. The Bernanke Fed has followed a deliberate course in setting monetary policy during this economic recovery. It will move slowly to ensure that the recovery is being sustained before moving to the next step. If the FOMC moves too quickly to normalize policy, and suddenly finds itself wanting more accommodation, the Fed will find it difficult to add to its portfolio again.

Therefore, the first step in our blueprint is for the Fed to stop expanding its securities portfolio, and this should happen by the end of June. Then the Fed should hold the size of its portfolio constant at around $2.6 trillion by reinvesting the proceeds of maturing Treasury and agency debt and agency mortgage backed securities (MBS) for a period of time, say three to six months. This will allow the Fed to observe market impact from its withdrawal as a major purchaser of Treasuries.

Next the Fed should begin slowly shrinking its balance sheet by not reinvesting the proceeds of maturing debt for a period of time. Again, this will allow the Fed to gauge whether the shrinking of its securities portfolio is harming the private sector. Assuming there is no discernable impact due to its withdrawal from the market for Treasuries, the FOMC will need to consider when to remove the “extended period” language from its statement, so as to signal its intention to begin raising rates in the near future.

It is important to note that Bernanke has the necessary support to keep from tightening policy too quickly. His views, along with those of his top lieutenants (New York President & FOMC Vice Chairman William Dudley; Vice Chair & sitting member of the Board of Governors Janet Yellen) strongly suggest the FOMC will not hike rates before 2012.