Fed chief faces task of picking right words
5/11/2010WASHINGTON - Words may speak louder than actions for Federal Reserve Chairman Ben Bernanke when the time comes to outline plans to raise interest rates and shrink the central bank's balance sheet.
Altering a pledge to keep short-term borrowing costs low or articulating plans to begin selling the $1.1 trillion in mortgage-backed securities it now holds will amount to a tightening of monetary policy because the announcements will send bond yields higher, raising borrowing costs, said Mitch Stapley, chief fixed-income officer at Fifth Third Asset Management in Grand Rapids, Mich.
Laurence Meyer, a former Fed governor, said that means Fed officials may be more likely than traders anticipate to keep the benchmark federal funds target rate near zero through the end of the year.
Mr. Bernanke's challenge is to calibrate communications so he and his colleagues retain the flexibility to pace and time their actions to the strength of the recovery.
"This market is going to discount anything they do from the immediate moment that the words pass their lips," said Mr. Stapley, who manages $13 billion in fixed-income assets. "The problem is the Fed needs the ability to work within shades of gray, and the market sees things in black and white."
As the economy rebounds from the worst financial crisis since the Great Depression, the Fed must decide when to cease saying that economic conditions "warrant exceptionally low levels of the federal funds rate for an extended period," a phrase it introduced in March, 2009. It also must determine how to normalize a balance sheet that ballooned to a record $2.3 trillion after the purchase of $1.25 trillion of mortgage-backed securities.
An announcement outlining how the Fed plans to unwind its portfolio is likely to widen by as much as 0.5 percentage point the yields on agency mortgage bonds relative to benchmark rates, according to Scott Buchta, head of investment strategy at Guggenheim Securities in Chicago.
Removing the "extended period" language would cause yields on two-year Treasury notes to increase by as much as 0.5 percentage point in the following two weeks, said Paul Gifford, chief investment officer at 1st Source Investment Advisors in South Bend, Ind. The notes yielded 0.81 percentage point, last week according to Bloomberg data.
A majority of Fed officials, led by Mr. Bernanke, has resisted changing key phrases in the Federal Open Market Committee's statement, even with three consecutive dissents from Thomas Hoenig, president of the Federal Reserve Bank of Kansas City. He says the current pledge limits the central bank's ability to raise rates.