The Federal Reserve’s policy-setting committee is not expected to announce any change in policy when it concludes a two-day meeting Wednesday. That means the central bank would continue purchasing a combination of Treasury bonds and mortgage-backed securities at a pace of $85 billion a month for at least another five weeks.
What the expected lack of shift in policy also means is that Wednesday’s action will probably take place at the news conference with Fed Chairman Ben Bernanke following the meeting. Here’s what National Journal will be listening for:
1. When will the Fed begin to back off its easy-money policy? The Fed is using two unconventional tools to drive down interest rates and spur economic growth. The first is a pledge to keep its benchmark short-term interest rate near zero until the unemployment rate drops to 6.5 percent (it’s currently 7.7 percent). This is known as forward guidance. The second is the $85 billion in monthly asset purchases mentioned above, also known as quantitative easing, or QE3. The central bank has said it will continue to make those purchases until the labor market improves “substantially.”
The Federal Open Market Committee, the central bank's policy-setting arm, hasn’t defined quantitatively what “substantial” improvement means. Last month Bernanke said, “We're looking for improvements in terms of employment, in terms of unemployment, in terms of a stronger economy that can deliver more jobs. The reason we haven't given a specific number, besides all the uncertainties involved, is that we're also looking at the efficacy and cost.”
Janet Yellen, who as vice chairman of the Fed’s Board of Governors is the central bank’s No. 2 policymaker, recently shed further light on how the Fed would be judging labor-market improvement. Yellen gave an in-depth look at the various data she will consider as she assesses the labor-market outlook. The jobless rate is one indicator, but she'll also be watching payroll-employment growth (which has averaged 187,000 a month since September, roughly the level economists say is needed to keep pace with population growth); the rates of hiring, layoffs, and quits; and the overall pace of spending and growth in the economy.
On Wednesday, Bernanke is likely to be pressed for any further details he's willing to provide on how he'll make the call to back off the easy-money policies. His interpretation of substantial labor market interpretation is key, but so is his assessment of the costs he's willing to put up with in order to achieve that improvement. For now, Bernanke has been clear that his cost-benefit analysis points in the direction of staying the course on QE. But as even Bernanke has acknowledged, there are risks, namely the concern that the easy-money policies could fuel an asset bubble.
2. How does the central bank plan to wind down its asset-purchase program and normalize policy without harming the economy? At some point, the economy will reach what’s known in Fed parlance as “escape velocity” and the highly accommodative policies the bank has pursued since the financial crisis will no longer be seen as necessary (for what it's worth, some lawmakers, economists, and even a few Fed officials don't think they are necessary right now). The transition out of the low interest-rate, expanding balance-sheet policies the Fed has been operating with since 2008 is expected to be tricky. A concern is that the Fed might run up inflation when it indicates it is taking its foot off the gas.
In June 2011, the Fed put forward an outline of an exit strategy in minutes from a policy-setting meeting. In a nutshell, the bank said it would begin raising the federal-funds rate before gradually and steadily selling the securities it has amassed on its portfolio until it returns to a more historically normal size.
Bernanke was asked during an appearance before the House Financial Services Committee in February whether that one-and-a-half year-old plan still stood. “We haven't done a new review of the exit strategy yet. I think we will have to do that sometime soon,” Bernanke replied.
But, he said, he's “pretty confident” that the basic outline released in 2011 “would still be in force.” He pointed to one place where the strategy might be updated: The securities in the Fed's portfolio could be held longer and allowed to run off when they mature, rather than sold outright. Bernanke estimated that might add a year to the unwinding of the Fed’s balance sheet.
More colorfully, he told the Senate Banking Committee on Feb. 26, “In terms of exiting from our balance sheet … we have a set of tools. I think we have belts, suspenders, two pairs of suspenders; we have different ways that we can do it.” He is likely to be asked to elaborate on that wardrobe on Wednesday.
3. How worried is Bernanke about asset bubbles, and will the Fed act if it spots one? A bubble forms when an asset price becomes unmoored from its fundamental value, often fueled by a belief among investors that the price will continue to rise indefinitely. It's what happened in the housing market before the financial crisis. There seemed little chance of a bubble forming as the economy limped along in the wake of the crisis. But now, more than four years into the Fed’s aggressive easy-money programs, the fear of a bubble inflating has returned.
Jeremy Stein, one of the Fed’s newest governors, jump-started the latest conversation on bubbles with a February speech in which he warned that investors might be taking on greater risks because of the low-interest rate environment the Fed had created. One of the big dangers is that such behavior is tough to spot until it’s too late and a bubble has burst (see: the housing market before the crisis). Another concern is that it’s unclear how — or if — the central bank can respond to potential bubbles without inflicting broader harm.
Kansas City Fed President Esther George, the Fed’s lone dissenter at its last meeting, said she cast her vote against the bank’s easy-money policies because they risked future “financial imbalances.” George noted in a January speech that “prices of assets such as bonds, agricultural land, and high-yield and leveraged loans are at historically high levels. A sharp correction in asset prices could be destabilizing.” And some economists are looking to the soaring stock market with a wary eye, worrying that some of the record highs reached by the Dow Jones Industrial Average this month may be fueled in part by bubble-like behavior.
George is the only voting member of the FOMC whose concerns have caused her to dissent, but the minutes from the bank’s latest meeting reveal she’s not alone in her worry over future financial imbalances. At the January meeting, “some noted that further asset purchases could foster market behavior that could undermine financial stability,” the minutes said.
Bernanke, who is one of the more dovish members of the committee, made clear in his latest semiannual testimony to Congress, delivered last month, that he doesn’t see the risks of a bubble outweighing the benefits of bond-buying at the moment. The press conference will be a chance to follow up on why, and to see if any developments in the past month have shifted his calculus.
And one more: How big a threat are Europe's woes? The latest European developments don't pose an immediate threat to the U.S. recovery. But the flare-up over a controversial bailout proposal for the tiny island nation of Cyprus was a reminder that the eurozone crisis isn't resolved and could be another headwind to the recovery in the United States. Indeed, U.S. stocks slumped Monday and Tuesday on the news.
Bernanke, if asked about Cyprus and the implications for the U.S. economy, may give a similar response to what he said in 2011 when asked to outline what the Fed can do in the face of challenges out of Europe. Then, he replied that U.S. economic policymakers can offer advice to European officials, and the Fed can assess the exposure and linkages between U.S. and European financial institutions and sovereign debt. But, he said, “Ultimately it’s [Europeans'] responsibility to find solutions to this very difficult problem.”