Federal Reserve faces pressure to provide clarity in uncertain environment

McClatchy Washington BureauJune 17, 2013 

Wall Street

What will happen on Wall Street tomorrow?

RICHARD DREW — AP

— Federal Reserve officials begin a pivotal two-day meeting Tuesday facing a dilemma. The economy is showing enough improvement to justify dialing back some of the Fed’s life support, yet financial markets are terrified of what might happen and are taking it out on the housing sector.

Members of the rate-setting Federal Open Market Committee are expected to announce on Wednesday that their benchmark interest rate will remain unchanged at near zero. But Chairman Ben Bernanke is likely to attempt to clarify in a news conference whether and when the Fed will begin tapering back its unconventional bond purchases that have boosted the economy.

Bernanke spooked financial markets on May 22 in congressional testimony, seeming to suggest that the Fed in coming months was likely to begin tapering off its monthly purchases of $85 billion worth of government and mortgage bonds. These purchases are known as quantitative easing and are in their third incarnation, dubbed QE3.

“If we see continued improvement and we have confidence that that’s going to be sustained, then we could in the next few (Fed) meetings . . . take a step down in our pace of purchases,” Bernanke told the Joint Economic Committee of Congress, declining to rule out that it could happen this summer

The Fed chief cautioned, however, “If we do that it would not mean that we are automatically aiming towards a complete wind-down. Rather, we would be looking beyond that to see how the economy evolves and we could either raise or lower our pace of purchases going forward.”

Financial markets didn’t like what they heard. The market-determined rate that the U.S. government pays on a 10-year government bond, called the yield, shot up from 1.58 percent on April 18 to 1.93 percent on May 21 to about 2.18 percent on Monday. Most unsettling is the rapid pace of the rise.

Therein is the dilemma. An improving economy should be cause for cheer. But the Fed’s unprecedented use of its balance sheet – purchasing more than $1.4 trillion in government bonds since late 2008 to help drive stock prices up and bond yields down – is so unusual that there’s no playbook for what happens when the purchases are tapered back and eventually eliminated.

“This was the danger of doing quantitative easing in the first place, the end game,” said Dean Croushore, a former Fed economist, co-author of a textbook with Bernanke and now a professor at the University of Richmond in Virginia. “I think there may be a little more worry than is justified in financial markets, especially if you look at inflation numbers.”

Investors have feared that the bond purchases would spark inflation when the economy roared back to life. It’s hardly roaring, but it has steadily improved and inflation remains subdued.

The Fed’s bond purchases have sought to force down the rate investors make when purchasing government bonds, trying to force them to chase better returns in the stock market and other riskier bets, bringing the added benefit of creating wealth that cascades through the economy.

So the sudden jump in bond yields is cause for concern. It makes it more costly for the U.S. government to issue new bonds to pay for spending that’s already occurred. And since mortgage rates take their cue in part from the 10-year bond, it has become more expensive since May 22 to buy a home or refinance an existing mortgage.

The interest rate on a 30-year fixed mortgage hovered around 3.94 percent on Monday, low by historical standards but up from 3.40 percent in December, most of the rise since May 22.

The rise in lending rates, if it continues, could slow what’s been a long anticipated recovery in housing. The June index from the National Association of Home Builders, released Monday covering activity in May, advanced 8 points, the largest spike in activity since September 2002.

“This report suggests that rates are having a constructive effect on builders. This helps support our call that if rates (creep) back up the economy will slow sharply,” warned Steven Ricchiuto, chief economist for Mizuho Securities USA, in a note to investors.

It all points to the need for clarity from the Fed, something that isn’t entirely expected.

“Some in the markets have speculated that the Fed will map out a timeline or conditions for tapering QE3 at this meeting. We do not believe there is enough agreement among Fed officials to do that,” Michael O’Hanlon, an economist with Bank of America Merrill Lynch, wrote in an investment note. “Conversely, there is a risk that the Fed makes only very modest changes to its statement language, and the markets interpret that as giving tacit support to the recent backup in rates.”

Email: khall@mcclatchydc.com; Twitter: @KevinGHall

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