Fed Weighs Timeline to Wind Down Its Deep Intervention in U.S. Economy

By Neil Irwin
Washington Post Staff Writer
Wednesday, September 23, 2009

Behind closed doors this week, leaders of the Federal Reserve are debating the best strategy for ending their aggressive efforts at supporting the economy, seeking to wind down programs on a timeline that neither stops the recovery in its tracks nor leads to a burst of inflation.

The Federal Open Market Committee, which began meeting Tuesday, is all but certain to leave unchanged its target for short-term interest rates -- in normal times, the Fed's main tool for influencing the economy -- near zero. But the statement that accompanies that decision, scheduled for release Wednesday, could shed light on the Fed's broader campaign.

In particular, the committee could signal how healthy it thinks the economy is looking and how quickly the Fed will extract itself from its massive program to support mortgage lending.

Fed leaders are trying to craft an exit strategy from this and other programs without causing disruptions in financial markets. One risk is that the Fed could set off new global gyrations if its exit is not coordinated with similar efforts by its counterparts overseas.

Some other central banks are also debating how to phase out the steps they took to combat the global recession. Bank of England Governor Mervyn King, for example, told a parliamentary committee last week that he considers the British economy still to be performing well below its potential, which analysts interpreted to mean the bank would not end its program of buying British government debt for some time.

The European Central Bank, which has been more worried about inflation than its peers, is not expected by investors to raise its bank lending rate, now at 1 percent, until late in 2010. Investors expect the Fed to raise rates sooner than that.

Unintended Consequences

The Fed has undertaken unprecedented intervention in the markets over the past year, sometimes leading to unintended effects on global finance. For example, with U.S. bank lending rates now lower than those set overseas by many other central banks, investors are borrowing money in the United States and lending it abroad, profiting from the difference. This activity, known as the carry trade, is lowering the value of the dollar relative to the euro and other major currencies. If the Fed moves aggressively to raise U.S. interest rates, the carry trade could evaporate, causing big swings in currency markets.

How fast the Fed decides to move depends in large measure on the strength of the nascent economic recovery. In other words, is it so weak that there could be a new wave of panic the moment that government support is scaled back?

"They have to acknowledge the fact that the economy is improving, but at the same time, acknowledge that we don't yet have an economy that's really rolling along strongly," said Bruce McCain, chief investment strategist at Key Private Bank.

At its last meeting, on Aug. 12, the Fed's policymaking committee said that data indicated "economic activity is leveling out." Since then, the prognosis for the economy has gotten even better, with forecasters widely expecting the economy to grow in the second half of the year. Fed Chairman Ben S. Bernanke confirmed last week that he shares that view when he said that the recession is "very likely over."

But the Fed has a delicate task in calibrating its language to reflect both an improved economic outlook and ongoing anxiety among many policymakers about whether the recovery will last.

"The economy seems to be brushing itself off and beginning its climb out of the deep hole it's been in," said San Francisco Fed president Janet Yellen in a speech Sept. 14. "But I regret to say that I expect the recovery to be tepid. What's more, the gradual expansion gathering steam will remain vulnerable to shocks."

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