The Fed’s five (not so) easy steps back to normal


(FILE) The U.S. Federal Reserve building in Washington. EPA/MATTHEW CAVANAUGH

The Federal Reserve is finally moving out of crisis mode.

In the six years since the financial crisis rewrote economic history books, the country’s central bank has held its benchmark interest rate at zero and pumped trillions of dollars into the U.S. economy. Now, it is getting ready to turn off the spigot and start draining the tub -- a complicated process that has become known simply as “the exit.”

Never before had the Fed provided so much support for the economy, so taking it away is an experiment in itself. Fed Chair Janet Yellen has promised a plan will be finalized later this year, though she hasn’t specified a date. The central bank did issue a notice stating it will discuss “medium-term policy issues” when its top officials gather in Washington this week for their regular policy-setting meeting. That is likely Fedspeak for “hammering out the details of the exit.”

Here is what we know so far, based on documents from previous meetings and public statements by Fed leaders.

Step One: End QE3.
The central bank has been slowly phasing out its controversial bond-buying program over the course of the year. Officials are expected to cut the monthly purchases -- which are designed to hold down long-term interest rates -- to $25 billion during their meeting this week, down from $85 billion a month at the end of last year. They will likely make another $10 billion reduction when they gather in September, then eliminate the final $15 billion at their October meeting.

The moment would mark the end of the central bank’s efforts to pump money into the economy -- a move that was often described as a “booster shot” for the recovery, albeit one that required three injections, the latest of which lasted nearly two years.

Step Two: Wait a ‘considerable time.
The Fed has taken great pains to emphasize that the end of bond-buying does not mean that interest rates will start to rise immediately. Here’s the (deliberately vague) official language:

The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain  the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.

How long is a considerable time? Yellen made waves this spring when she suggested it could be “about six months” -- putting the first rate hike in spring 2015 --  though she has since focused on the uncertainty in the central bank’s forecast. Translation: We left it vague for a reason. And if inflation remains low, the Fed will feel more comfortable taking its time.

Economists’ forecasts put the moment of liftoff around the middle of next year. But a Bloomberg survey of interest rate projections show a significant percentage believe the Fed might wait until the fall, or even later.

Step three: Raise rates
Deciding when to raise interest rates is only part of the question. The Fed must also figure out how it wants to move.

Should it move the benchmark Fed funds rate by 25 basis points, which is considered a standard adjustment and would signal officials are moving cautiously? Or will it need to be more bold, perhaps hiking by 50 basis points? Should it increase rates at every meeting, or go more slowly?

Fed officials would answer that the strength of the recovery will determine their response. But if the market tantrum last year over the anticipated end of its bond-buying program taught them anything, it’s that no one likes surprises. The central bank’s steady drawdown of stimulus this year, despite several unexpected turns in economic data, shows that they’ve learned their lesson. It’s likely that when the Fed does begin to raise rates, it will move in a methodical, predictable way -- though always leaving the door open to course correction.

That means the meeting after liftoff will be especially important. It will help set the pace for the rest of the journey back to normal.

There’s also the issue of mechanics. The central bank will continue to use the fed funds rate -- rate at which banks lend to each other overnight -- as its main channel for communicating its policy position. But it plans to use the rate it pays banks on excess reserves held at the Fed to help it hit that target.

Officials are more skeptical of a related tool, called the overnight reverse repo, that would allow financial institutions that aren’t banks to stash money at the Fed for a small interest rate. Advocates of the idea, such as former Fed governor and Harvard economist Jeremy Stein, believe it could help solidify the floor under the central bank’s target for interest rates. But at the Fed’s last meeting, many officials worried it could also distort private short-term lending markets.

Step 4: Shrink the balance sheet.
Raising interest rates is only one half of the equation. At some point, the Fed will also have to start shrinking its balance sheet.

The central bank's assets have more than quadrupled to roughly $4.5 trillion since financial crisis as the Fed pumped money into the economy. Reducing its holdings is a way of draining the tub.

Former Fed Chairman Ben S. Bernanke floated the possibility when he was in charge that the central bank would not have to actively sell its assets but could simply let them runoff as they mature, and Yellen is on board with that idea. So far this year, for example, the balance sheet would have shrunk by an average of $14 billion this month -- except that the Fed is reinvesting that money into new purchases to ensure the balance sheet stays stable. That’s why officials were so picky about saying that tapering isn’t tightening: They are adding less and less to the balance sheet, but they aren’t taking anything away yet.

When will that happen? At their last meeting, officials seemed largely to agree to wait until after the first rate hike to end those reinvestments. But exactly how long after remains an open question.

Step 5: Return to normal -- or not.
So now QE is over, interest rates are moving on up, and the balance sheet is shrinking. You’d think the hard part would be over. It’s not.

There is a broader, philosophical debate hanging over the entire U.S. economy right now. Will the road to recovery ever lead us back to what we considered “normal” during the Great Moderation? Or are we stuck in a slump of permanently lower growth?

Economists are still duking this one out -- and even those on the same side might disagree on the reasons why. The answer has big implications for the Fed: If the economy doesn’t get back to “normal,” then interest rates won’t get back to the normal. The latest Fed forecasts show officials starting to mark down their expectations for long-run rates from 4 percent to 3.75 percent.

Of course, the central bank’s forecasts for even a year ahead have been notoriously inaccurate. That makes the long-run estimates educated guesses at best.

 

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