Adjusting bond buying isn't the Fed's only focus

Although financial markets will be fixated Wednesday on the Federal Reserve's expected decision to dial down its bond-buying stimulus, Fed policymakers also could make other significant moves.

More than 60% of 44 economists surveyed by USA TODAY last week say the Fed will reduce its $85 billion in monthly bond purchases, which are aimed at holding down long-term interest rates and spurring economic growth. The Fed has said it will taper the purchases gradually and likely end them by mid-2014, assuming the economy and job market continued to improve.

Other things to watch for Wednesday out of the Fed's statement and Fed Chairman Ben Bernanke's afternoon news conference:

• A change in interest rate guidance. Several economists say the Fed could lower the threshold for raising its benchmark short-term interest rate. Fed policymakers have said they'll keep the fed funds rate near zero at least until unemployment, now 7.3%, falls to 6.5%, provided the inflation outlook is below 2.5%. Most Fed policymakers have previously forecast the first rate hike for 2015.

The Fed could lower the unemployment threshold to 6% to account for the fact that a recent sharp drop in the jobless rate largely has been due to many Americans dropping out of the labor force, rather than healthy growth in employment. If most of those dropping out are Baby Boomers retiring, the resulting decline in unemployment is likely enduring, but not if they're discouraged workers who will eventually resume their job searches.

Another reason to lower the 6.5% threshold is to emphasize that a reduction in bond-buying doesn't herald an earlier boost in short-term interest rates, as many investors have mistakenly assumed.

"I think markets are comfortable with (a cut in bond-buying) as long as the Fed makes clear that the fed funds rate isn't going anywhere soon," says Richard Moody, chief economist of Regions Financial.

Other economists say the Fed is unlikely to modify the 6.5% threshold. In a research note, Barclays Capital notes that "a significant portion" of the Fed's policymaking committee believes that a 6% unemployment rate now constitutes "full employment" in the U.S. Thus, the Fed would be inviting high inflation if it waited until the economy reached full employment before raising short-term rates.

At the July Fed meeting, policymakers discussed lowering the threshold. Several said such a move might suggest that the threshold "could not only be moved down but also up, thereby calling into question the credibility of the thresholds and undermining their effectiveness," according to the meeting minutes.

That shows "that there is far from a consensus on this topic," RBC Capital Markets said in a research note.

• More guidance on inflation. Alternatively, the Fed could add another qualifier to the 6.5% threshold, saying it will also keep interest rates near zero as long as inflation is below about 1.5%, says Jim O'Sullivan, chief US economist of High Frequency Economics.

Inflation has been running at 1.2%, well below the Fed's 2% target and a symptom of a slow-growing economy. Adding an inflation threshold "would talk down bond yields," which have risen sharply since May, but in a less disruptive way than cutting the unemployment threshold, O'Sullivan says. The Fed, he says, also could simply add stronger language to its statement about keeping interest rates near zero until inflation picks up, without specifying a specific level.

• Important changes in the Fed's forecasts for economic growth and unemployment. Given the current 7.3% jobless rate, its year-end unemployment forecast could be trimmed from its March projection of a range of 7.3% to 7.5%. Yet, the Fed's 2013 economic forecast of 2.3% to 2.8% also could be cut slightly, O'Sullivan says, largely because of weak first-quarter growth of 1.1%.

Perhaps more critically, Fed policymakers for the first time will provide their forecasts for the fed funds rate in 2016.

In March, they projected that the rate, now 0.25%, will rise to 1% by the end of 2015, according to their median forecast. Since the economy likely will be approaching full employment by 2016, their median fed funds rate forecast for the end of 2016 could rise to 2.5% — a level that might push up short-term interest rates, O'Sullivan says.


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