Scenarios: Fed to tread lightly, verbosely, toward exits

By Pedro Nicolaci da Costa

NEW YORK (BestGrowthStock) – Federal Reserve Chairman Ben Bernanke’s testimony to Congress on Wednesday confirmed what many already knew: the central bank’s approach to withdrawing monetary stimulus will be slow, cautious and well-telegraphed.

An increase in the discount rate charged to banks for emergency loans, implemented last week, had sparked some speculation that the Fed might be getting ready to actively push borrowing costs higher.

Not so fast, Bernanke indicated in his latest remarks. A weak labor market means the private economy is still too fragile to be left to its own devices, and will likely require extraordinary assistance from the central bank for at least several months more.

The Fed says it will be very clear about testing the waters and previewing policy moves, and clues are likely to emerge from the central bank’s shifting assessments of economic conditions in its policy statement.

Timing and sequencing are still fuzzy, but here is the most likely series steps to watch for as the Fed moves toward tightening financial conditions.

* Discount Rate Hike: The Fed could choose to further increase the discount rate as part of what it describes as a “normalization” of liquidity measures. Before the crisis, the discount rate was a full percentage point higher than the federal funds rate. The financial crisis prompted the Fed to narrow that spread to a quarter percentage point, and last week’s discount rate increase brought it back up to 50 basis points, leaving room for further rises.

* Complete Testing of Tools: Both the minutes of the Fed’s January meeting and Bernanke’s latest testimony offered a few tangible benchmarks for financial markets. The Fed says it will begin testing the term deposit facility in spring, and that it will be operational soon after. It is also developing the ability to use mortgage securities as collateral for reverse repurchase agreements, and to conduct the transactions with a broader range of counterparties. It expects to be ready on this front in the second quarter.

* Remove, Alter “Extended Period”: The Fed will eventually have to drop or tweak its pledge to keep rates near zero for a prolonged period. It could first water it down, as Kansas City Fed President Thomas Hoenig has suggested. The central bank will likely wait at least several months after omitting the term from the Fed’s statement before raising official interest rates. Look for ample warning this step is coming, through Fed meeting minutes and public comments from officials.

* Reverse Repos: Given Bernanke’s influence as Fed chairman, investors paid close attention to a speech earlier this month outlining what he saw as the most likely exit path. He envisions a “scaling up” of reverse repos from a testing phase to a size that will actually drain reserves. He is also keen on using the interest the Fed is allowed to pay on bank reserves to dissuade banks from lending if inflation picks up.

* Raise Rate of Interest on Reserves: a policy tightening will eventually ensue via an increase in the rate the Fed pays banks to hold their excess reserves, an authority granted by Congress following the financial crisis. The idea is that the fed funds rate no longer responds to Fed jawboning because of the sheer volume of reserves out there, up near $1.2 trillion at the moment from somewhere near $5 billion-$6 billion before the crisis. This tool may be used in conjunction with reserve drains, particularly if fed funds rate does not appear to react initially to the Fed’s policy shift.

* Asset sales: Minutes to the Fed’s January meeting indicated several members might actually favor selling securities as an integral part of the exit strategy. The Fed is almost done buying more than $1.4 trillion in mortgage linked debt, and also acquired $300 billion in Treasury bonds. If the idea of selling assets gains favor, or if inflation picks up unexpectedly, the Fed might institute a structured program of sales for these securities. “I currently do not anticipate that the Federal Reserve will sell any of its security holdings in the near term, at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery,” Bernanke said in his February 10 speech. “Any such sales would be at a gradual pace, would be clearly communicated to market participants, and would entail appropriate consideration of economic conditions.”

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Scenarios: Fed to tread lightly, verbosely, toward exits