Fed Debates How to Signal Next Rate Move
By Jon Hilsenrath and Sudeep Reddy
The Wall Street Journal
March 10, 2010
Long before the Federal Reserve raises short-term interest rates amid an improving economy, it will need to signal to the public that a change is in the works. Central-bank officials are intensifying discussions about how to communicate that when the time comes.
For the past year, the Fed has signaled plans to keep interest rates near zero for a long time. Although officials aren't yet ready to change that wording, they are trying to think through a script well in advance for how to walk away from that pledge.
The issue will be at the center of discussions at the Fed's meeting next Tuesday. Central-bank officials also are likely to decide at the meeting to end their purchases of $1.25 trillion of mortgage-backed securities by the end of this month, as planned, according to Fed officials.
Although the housing market has softened recently, the broader economy appears on track to grow at about a 3% rate in the first quarter, enough to start creating jobs.
Futures markets anticipate the Fed will raise its target for the fed funds rate—a rate banks charge each other for overnight loans—to 0.5% from near zero by November or December.
"The markets seem prepared for the risks toward tighter policy," Brian Sack, director of the New York Fed's markets group, said in a speech Monday.
At some point, the Fed must undertake some delicate wordsmithing in the statement it releases after policy meetings.
The current language—that officials plan to keep rates "exceptionally low" for "an extended period"—is meant to convey that rates will stay near zero for at least several more months.
A change is highly unlikely at next week's meeting. Many officials believe a recovery isn't fully enough entrenched. Inflation is so low that they're under little pressure to act.
"I can envision that [the current stance] will continue to be appropriate for quite some period of time," Charles Evans, president of the Chicago Fed, said in an interview Tuesday.
Timing depends on the economy. If it weakens or fails to produce jobs, rate increases are off the table. If it heats up, increases could come sooner.
The Fed has botched its communications in the past. In 1994, for example, investors were surprised by rate increases, and bond-market turmoil ensued. In 2004, some officials felt the Fed tied itself to increases that were too gradual.
Different ideas are being bandied about now.
Officials could say rates will stay exceptionally low for "some time," meaning the time for a rate increase is slowly getting closer, or that Fed policy will stay "highly accommodative," meaning rates might rise but not by much.
As part of the planning, officials are studying how the Fed performed in 2004, when it shifted from saying rates would stay low for a "considerable period" to saying it would be "patient" before raising rates, to saying rates would rise at a "measured" pace.
In addition to debate at official meetings every six weeks, there is a great deal of jockeying ahead of meetings. For example, Fed staff circulate a document, called a blue book, in which officials are shown options for how they might alter communications.
Inflation hawks are agitating to drop the "extended period" words, worried that keeping rates too low for too long will push up prices more than desired. Thomas Hoenig, Kansas City Fed president, dissented at the last meeting because he wanted the words removed.
"I am not a big fan of that language," Charles Plosser, Philadelphia Fed president, said in an interview. The words "confine us."
The end of mortgage purchases looks more certain. The central bank's program is credited with pushing mortgage rates down by as much as one percentage point, lowering other long-term interest rates and helping the housing sector.
Some investors worry mortgage rates could shoot up without the Fed's support. But officials have been comforted by the fact that rates haven't moved up even as they have slowed their buying.
The market reaction to a Fed pullback "will actually be a pleasant surprise," said Ajay Rajadhyaksha, Barclays Capital's head of U.S. fixed-income strategy.
When the Fed became the dominant buyer of mortgages, big investors such as mutual funds and insurers walked away from the market and purchased Treasury debt instead. Once the Fed stops, Mr. Rajadhyaksha said, there will be pent-up demand from private investors to soften the impact.
He expects Treasury and mortgage yields to rise no more than half a percentage point in coming months. Today, yields on 30-year fixed mortgages are around 5%.
The Fed plans to gradually reduce its mortgage portfolio. As mortgage-backed securities are paid off by borrowers, it plans to avoid reinvesting the proceeds in new securities. Mr. Sack estimates $200 billion of mortgage-backed securities will be pared from the Fed's portfolio this way through 2011.
Officials are debating whether to adopt a similar policy for $140 billion of Treasury securities held by the Fed that mature by 2011.
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