The Federal Open Market Committee will meet this week to set monetary policy. The FOMC is widely expected to further taper the monthly pace of asset purchases (not “on a preset path,” but continuing “in measured steps”). The bigger question is when the Fed will begin to raise short-term interest rates. The correct answer is “it depends.” Fed officials are currently debating the order of steps to be taken as they begin to normalize monetary policy. If all goes well, the first rate hike is seen as likely around the middle of 2015. However, monetary policy in 2015 will depend on the evolution of the economic outlook and financial conditions in the second half of 2014 – and the second half outlook is looking more uncertain.
Former Fed Chair Ben Bernanke had suggested that the first step in removing policy accommodation would be for the Fed to end the reinvestment of maturing assets in its portfolio. Currently, the Fed purchases mortgage-backed securities and long-term Treasuries to replace the securities that mature, keeping the size of the balance sheet steady. The expansion of the balance sheet was meant to put downward pressure on long-term interest rates. Many at the Fed now believe that the economy, especially the housing market, may need long-term rates to remain low for a longer period. Fed officials have tried to emphasize that short-term interest rates aren’t going to be raised anytime soon, and not rapidly once that starts. That helps keep long-term rates low. However, market perceptions of when and how fast the Fed will raise short-term interest rates can change quickly. Long-term interest rates can be thought of as a series of short-term interest rates. Hence, if the market expects the Fed to act sooner and more aggressively on short-term interest rates, long-term interest rates would be higher than the Fed would like them to be. In contrast, by reinvesting maturing securities in its portfolio, the Fed would be better able to keep long-term interest rates from rising too rapidly. Hence, the Fed is likely to delay the end of the reinvestment policy. This has been one factor behind the decline in long-term rates.
Eventually, the Fed will reduce the size of its balance sheet by simply letting the securities in its portfolio mature without replacement. Some time back, the Fed indicated that it did not plan to sell mortgage-backed securities and there is growing speculation that the Fed won’t sell its holdings of Treasuries either. Fixed income market participants don’t have to worry about the Fed dumping securities. That could still happen if there were a major threat of higher inflation (caused by substantial growth in loan creation), but it’s unlikely.
The first step in policy normalization is now expected to be an increase in short-term interest rates – but which rate? The Fed now pays interest on excess reserves held at the Fed. In raising the interest rate paid on excess reserves (IOER), the Fed discourages banks from lending reserves. It’s unclear whether the Fed will raise the IOER before the federal funds target rate (the overnight lending rate, which has been the traditional lever for monetary policy), in tandem, or in reverse order.
The Fed has other ways to drain reserves from the banking system when appropriate. It can do reverse repos, lending Treasuries or MBS on a short-term basis. It can also issue time deposits for depositary institutions (tying up bank reserves for a certain period). The Fed has tested these options regularly over the last few years, but there are some concerns about whether the Fed can scale these up in a hurry if they have to.
Fed officials will continue to debate exit plans over the next few months, but should let market participants know once the outlook is settled and the need to begin normalizing policy gets closer. There’s some potential for investors to be confused and the Fed will have to be careful in how it manages expectations.
Meanwhile, the economic outlook for the second half of the year has become more clouded. The first quarter was essentially a weather story. The second quarter is a recovery story. Averaging the two, the first half of 2014 may seem a disappointment. GDP growth for the first half of the year will be a lot less than was expected at the start of the year. However, much of that is due to an inventory correction and a widening in the trade deficit. One problem with the GDP figures is that imports have a negative sign. As the U.S. economy improves, we consume more domestic goods and services, but we also consume more imports (which subtracts from GDP).
Much of the uncertainty in the second half outlook is related to issues from the first quarter. Spring is the critical time of year for the housing sector and results for this spring fell far short of expectations. Global economic growth was also softer than expected, restraining exports. Housing and foreign trade are not going to throw us into a recession in the second half of the year, but they could keep GDP growth below expectations.
The insurgent uprising in Iraq adds to global tensions. In contrast to the 1970s, when OPEC oil price shocks quickly fed through to inflation in the labor market, higher oil prices are now seen as a restraint on economic growth (rather than a catalyst for a higher underlying trend in consumer price inflation). Developments in Iraq can be added to a growing list of worries about the second half of 2014. The stock market often climbs a wall of worry, but sometimes the wall wins.
With federal fiscal policy still in contractionary mode (but less so than last year), monetary policy remains the only game in town. Fed policymakers are unlikely to show their hand until the outlook clears up, but that will take some time.