Attempts at Relief and Reform

Fed's Next Step Uncertain As QE2 Stimulus Ends

Posted on Thursday, May 5, 2011

NEW YORK -- When Federal Reserve chairman Ben Bernanke holds his first-ever press conference on Wednesday, he will have some explaining to do. Two months from the scheduled end of the Fed's stimulus program, the economic recovery remains weak.
Since the Fed's asset-purchase strategy began last fall, corporate America has gotten a boost, as borrowing has become cheaper and the stock market has rallied. But the broader economy still struggles. Home prices hit a new low in February, and unemployment, though improved, remains high. Most recently, rising oil prices have wounded consumer confidence, stoking fears that the nation could slip back into recession.
The $600 billion asset-purchase program, dubbed "quantitative easing" or "QE2," is intended to spur the recovery. Since November, the New York branch of the central bank has been buying new U.S. government debt from private firms, bidding up the price of Treasury securities and causing yields to fall. Those falling yields, in turn, have pushed down interest rates across the economy, making borrowing cheap and, in theory, stimulating business activity.
Once this quantitative easing program ends, the economy will be missing a major source of support. Interest rates could rise if demand for U.S. debt slackens, or they might fall further if investors pile into Treasuries for shelter. In either case, the economy will face a test as it attempts to stand on its own two feet.
"The Fed is trying to walk this very difficult, fine line," said John Silvia, chief economist at Wells Fargo.
While the Fed isn't likely to initiate a third quantitative easing program, there will be some on the Fed committee who will say, "Wait a minute. We can't really pull this back until we see more sustainable growth, or some kind of direction of where inflation is going," Silvia said.
The economic recovery has been uneven, and the Fed's stimulus seems to have given a disproportionate boost to the corporate sector.
"The Fed took away the downside uncertainty," said John Richards, head of North American strategy at the Royal Bank of Scotland. "It signaled to the market loud and clear that it was willing to do almost anything it had to do to have the U.S. not go into a deflationary situation."
But some economists fear that with the end of quantitative easing, the market will fall to where it otherwise would have been without the Fed's help.
It's this possibility, among others, that Bernanke will likely be asked to explain Wednesday. Investors will hang on his every word.
* * * * * *
Just a few months ago, it seemed the recovery was picking up steam. Holiday sales were stronger than expected. In February, as the unemployment rate dipped below 9 percent, consumer confidence reached a three-year high.
But then, conflict in the Middle East helped push oil prices to their highest level since 2008, when months of record-high prices dragged the economy into recession. A devastating earthquake and tsunami struck Japan in March, crippling that country's exports and sparking global fears of nuclear contamination. That month, consumer sentiment fell to its lowest level since November 2009.
In April, the International Monetary Fund cut its forecast for annual U.S. economic growth by the same degree as it cut its forecast for Japan.
Brent crude oil, an industry benchmark, is now trading above $124 a barrel, perilously close to its 2008 high of $145. Some economists fear a scenario in which weak growth combines with steadily increasing prices, driven upward by oil.
"Prices do pass through to things like airfares and distribution costs," said Kevin Logan, chief economist of HSBC. "Instead of seeing a downward pressure on other prices -- so that everybody cuts their margins, or looks to whatever productivity gains they can squeeze out of the processes to keep their prices down -- instead, you just get slightly higher increases all along the line. That's a risk."
Still, the stock market has surged despite these drags. Since Bernanke first hinted in an August speech that the Fed might launch a new round of asset purchases, the Dow Jones Industrial Average has climbed 24 percent. The Standard & Poor's 500 Index has gained more than 26 percent.
With the Fed buying massive amounts of U.S. debt, interest rates have fallen, and investors, in search of yield, have been pushed into riskier assets, such as equities and corporate bonds, propelling the stock market to highs last seen in the first half of 2008. That's created a situation in which the value of these assets is partially determined by government intervention.
Since quantitative easing began last fall, the Fed's purchases of U.S. debt have amounted to more than 80 percent of the Treasury's debt issuance, according to Fed and Treasury data. Those purchases have effectively crowded out private investors, pushing them into equities, which, in turn, have rallied.
The Fed's balance sheet has grown 17 percent since the program began, to nearly $2.7 trillion, according to Fed data. The central bank's holdings of Treasury securities have increased by more than two-thirds in that time.
The program is scheduled to wrap up by the end of June. When that happens, stocks could experience a jolt.
"The thing that you get here with the end of QE2 is an equity market that is probably overdue for a correction," said Richards, of RBS. "The end of QE2 could maybe trigger it."
Economists disagree on how the end of quantitative easing will affect interest rates. Some take the view of Pimco co-chief investment officer Bill Gross, who wrote in a note last month that the Fed's exit from the Treasury market will create a sudden dearth of demand, causing bond prices to fall and interest rates to rise. That problem could be compounded if Japan, the foreign country with the second-largest holding of U.S. debt, shows weaker demand for Treasuries as it spends its money on domestic rebuilding, noted Bernard Baumohl, chief global economist of the Economic Outlook Group.
Higher Treasury yields would push up rates across the economy, making it more expensive for prospective homeowners to get mortgages, for students to take out loans and for small business owners to get lines of credit. It could constitute yet another strain on the economy.
But other economists expect interest rates to fall once the Fed's program ends, as the economic outlook remains uncertain. Investors will seek the safety of Treasury bonds and thereby push yields downward, said Logan, the HSBC chief economist. Long-term interest rates fell after the Fed's first round of quantitative easing ended early last year.
But while these effects are unknown, the timeline likely won't be. The Fed's main policy-making body is meeting on Tuesday and Wednesday, and is expected to announce the official end date for quantitative easing, giving investors time to prepare.
"The vast majority of people in the market expect QE2 to end in June, on schedule," said Andrew Tilton, an economist at Goldman Sachs. "If everyone's expecting that, it would be odd for there to be a sudden disruption in the market as soon as that actually happens."
With the unemployment rate high and core inflation low, economists and investors expect the Fed to keep the main interest rate near zero for at least several months after the asset-purchase program ends, in an effort to keep money flowing through the economy. New York Fed President William Dudley said in a speech this month that the economic recovery is "still tenuous," and still short of the central bank's goals.
Traders in the Chicago Mercantile Exchange are betting the Fed won't raise the main interest rate until sometime between December and January.
Further, some economists say the Fed will maintain the size of its Treasury holdings even after quantitative easing ends, by reinvesting maturing debt. That might help wean the economy from the Fed's stimulus, Bloomberg News reported last week.
But there's yet another risk: that Bernanke will spook investors when he speaks to reporters on Wednesday.
"One of the great challenges he's going to have is being very, very careful to use the right adjective or right adverb," said Silvia, the Wells Fargo chief economist. "What is 'sustainable growth'? I'm not sure what that means. What is 'accelerating inflation' as opposed to 'modest inflation'?"
A misplaced word could move markets.

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