These are the buzzwords to watch for as the Fed plots its exit strategy

May 15, 2013

The Federal Reserve has long been infamous for carefully crafted, sometimes impenetrable pronouncements about the state of the economy and its own policy decisions. But trying to decipher this communication has become even more challenging over the past five years as the central bank has rolled out increasingly complicated and untested tools to avoid another Great Depression and boost the recovery.


Turn the dial on some state-contingent buzzwords. (Karen Bleier/AFP)

The Fed has tried to be more open and transparent, but officials still rely on a vocabulary of code words to convey their states of mind. Philadelphia Fed President Charles Plosser gave a speech this week in Stockholm that was packed with buzzwords to describe the Fed's plans to slow and then unwind its monetary stimulus policy -- terms that are popping up in a lot of Fedspeak now as officials start to recalibrate their plans for an exit. Here are the terms to know:

Exit strategy. This is the overall strategy for moving from current Fed policy -- near-zero interest rates and a $3 trillion balance sheet with another $85 billion in bonds being added -- to whatever the Fed's monetary policy stance will look like as the economy gets closer to normal. The caveat is that the only part of the “strategy” that Fed officials have definitively agreed on is that there will be an exit one day. What that will look like and when it will happen are still up in the air.

Flexibility. The Fed doesn’t want to paint itself into a corner. Officials agree that they need to end bond purchases at some point but are worried that the economy and the markets will freak as soon as it starts to turn the dial down. (More on the dial in a moment.) It’s also possible that the Fed is misjudging the recovery. It has forecast that the economy will grow between 2.3 percent and 2.8 percent this year, but officials are careful to note that there are significant risks to that prediction. The Fed has a track record lately of overestimating the strength of the economy; for the past four years, it has consistently forecast robust growth a year away, which hasn't materialized. Priming the public for a “flexible” Fed is a way for the central bank to cover its bases.

State-contingent. This is Fed officials' way of saying that they will respond to whatever the economy does. If the recovery is going well, game on, exit strategy! If things go south, they can turn that dial the other direction. Speaking of which . . .

The dial. The Fed has said that it doesn’t want to quit buying bonds cold turkey. It would like to slowly reduce the amount of purchases, though how much and how quickly are tricky questions. But officials are worried that as soon as they start to “dial down” those purchases, markets will assume the worst and start acting as if the Fed had stopped buying bonds altogether, sold them off, raised interest rates and gone on a long vacation to the Caribbean – a reaction that would negate the power of the remaining purchases to stimulate the economy. Enter the dial. A dial can move fast or slowly or can stop moving. The Fed hopes that using this analogy will help give it the flexibility to adjust to the state of the economy.  A dial can move up, as well as down. So if the economy really tanks – or, say, if deflation becomes a serious threat – the central bank could buy more bonds than it's buying now. The Fed might also turn the dial down only to turn it back up later.

All of this is a long way of saying that the Fed can do whatever it wants, whenever it wants, but that it still isn’t sure what it wants to do. As Plosser put it in his speech: “We are in uncharted territory in this regard and should be appropriately cautious in specifying too detailed a path that we may not be able to follow.”

In other words, we'll let you know.

Ylan Q. Mui is a financial reporter at The Washington Post covering the Federal Reserve and the economy.
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