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On March 25, 2010, Federal Reserve Chairman Ben Bernanke went before the House Financial Services Committee to outline exit strategies, or tools the central bank could use to drain the $1 trillion of excess reserves held by the banking system. At the time, financial markets were focused on whether the Fed would be able to bottle up those reserves, once the economy improved, to prevent an inflationary expansion of credit.
Last week, Bernanke was back on Capitol Hill to deliver the Fed’s semiannual report on monetary policy and the economy. There is to be no exit, at least in the near-term. There is no new exit strategy other than the one previously disclosed. (Speculation the Fed would lower or eliminate the interest rate it pays on reserves turned out to be just that.) And that exit door he talked about four months ago? It has “enter or exit” written on it now.
“We remain prepared to take further policy actions as needed to foster a return to full utilization of our nation’s productive potential in a context of price stability,” Bernanke told the Senate Banking Committee Thursday, reiterating an option the Fed discussed at its June 22-23 meeting.
What’s changed between March and July to increase the risks to the economy and thus temper the Fed’s outlook for a self-sustaining recovery?
For starters, the stock market is lower, credit spreads are wider and financial conditions are less supportive, all of which Bernanke mentioned in his testimony.
Unlike his predecessor, Bernanke steers clear of fiscal policy, addressing deficits and debt in the broadest of terms without recommending specific tax and spending initiatives. If he had wanted to stray from the reservation, he could have told his audience fiscal policies were producing whiplash – in both the economy and the Fed’s outlook for it.
Housing, for example, fell out of bed once the government’s homebuyer tax credit expired on April 20. New home sales plummeted to an annual rate of 300,000 in May, the lowest on record. Homebuilder sentiment slumped in June and July, according to the National Association of Homebuilders, auguring further declines in sales. (The NAHB Index includes measures of sales, traffic and expectations of future sales and generally leads the complex of housing indicators.)
Retail sales sputtered in the spring, along with consumer confidence. Cash for clunkers produced auto sales then (last year) instead of now.
At their June meeting, Fed officials downgraded their forecast for economic growth and inflation and job growth. None of the changes were material. The Fed now expects, on average, an unemployment rate of 7.5 percent at the end of 2012, real GDP growth of 4 percent and inflation of 1.4 percent.
A double-dip recession isn’t part of the Fed’s forecast (neither was the worst financial crisis since the Great Depression). Nor is deflation a “near-term risk for the United States,” Bernanke said in the Q&A, citing stable inflation expectations. (What if those expectations are wrong?) Bernanke said the Fed has options, albeit unconventional ones, if those forecasts turn out to be wrong. He specified expanding the Fed’s balance sheet, reducing the interest rate on excess reserves and committing to low interest rates (an extended “extended period”).
In early April, fed funds futures were priced for a 50- basis-point increase by year end. Now the likelihood of a first rate increase has been pushed off until September 2011.
As recently as the June 22-23 meeting, Fed policymakers were discussing a return to a Treasuries-only portfolio, according to the meeting minutes. A few participants preferred the return be sooner; most opted for later, after the Fed starts to raise short-term rates.
Bernanke provided an update on the Fed’s portfolio yesterday even as the time frame for normalization seemed to float forward.
Currently only one-third of the Fed’s assets are Treasury securities compared with 100 percent prior to September 2008. At the same time, courtesy of the Fed’s $1.25 trillion mortgage-backed securities purchase program, the average maturity of the Fed’s portfolio has doubled to seven years, which will restrain the Fed’s profit (turned over to the Treasury) in a rising interest-rate environment.
Some policymakers are anxious to return to a Treasuries-only policy and get out of the credit business. That’s how it should be: the Fed providing reserves to the banking system in a neutral fashion without picking winners and losers.
My concern is there will never be a good time to shed mortgage assets. The housing recovery will be a multiyear process, once it stops going down. Who wants to rock the boat?
Finding the entrance is easy. The hard part is walking through the exit door.
Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.
