Fed to Start Unwinding Its Stimulus Next Month

The New York Times

18 December 2013

The Federal Reserve said on Wednesday that it would gradually end its bond-buying program during 2014, a modest first step toward unwinding the central bank’s broader stimulus campaign as its officials gain confidence that the economy is growing steadily.

The Fed plans to cut its monthly purchases of Treasury and mortgage-backed securities from $85 billion in December to nothing by the end of next year in a series of small steps, starting with a reduction to $75 billion in January, the central bank announced after a two-day meeting of its policy-making committee.

At the same time, the Fed sought to offset concerns that it was once again pulling back too soon by strengthening its plans to hold short-term interest rates near zero, which officials regard as a more powerful means of stimulating growth. Both policies aim to hold down borrowing costs and revive risk-taking.

The Fed’s shift in policy, in effect, means it plans to do less now and more later. That is a result of a compromise that has been months in the making between a group of officials convinced that the economy needs more help, and a range of internal critics who regarded the bond-buying campaign as ineffective or dangerous.

The Fed’s chairman, Ben S. Bernanke, insisted that the net effect was not a withdrawal of support for the economy.

“We are not doing less,” he said at a news conference on Wednesday. “I think we have been aggressive to try to keep the economy growing, and we are seeing progress in the labor market. I would dispute the idea that we are not providing a lot of accommodation to the economy.”

Investors appeared to agree with Mr. Bernanke, defying predictions that stock prices would retreat along with the Fed’s pullback. Major stock indexes spiked when the Fed’s statement was released at 2 p.m., and the Standard & Poor’s 500-stock index rose 1.7 percent by the end of the trading day. Importantly, interest rates on benchmark bonds — the rates the Fed is trying to influence — ended the day roughly where they started.

One reason for investor enthusiasm, said Michael Hanson, senior economist at Bank of America Merrill Lynch, is the stimulus will be withdrawn very gradually.

The markets now have a clear — though tentative — schedule for the course of Fed policy over the next two years, including an end to asset purchases by late next year and a signal from Mr. Bernanke that the first increase in short-term interest rates is not likely to come until near the end of 2015.

That is particularly striking because the plan, set in the final months of Mr. Bernanke’s tenure, will now define the first two years of the term of his successor, Janet Yellen, whom the Senate is expected to confirm this week. Mr. Bernanke said on Wednesday that Ms. Yellen “fully supports what we did today.”

The Fed is struggling to calibrate its stimulus campaign in an environment of steady but mediocre growth. The unemployment rate has declined over the last year, reaching 7 percent in November. But that is still a high rate by historical standards, and other measures of the labor market look even worse. Wages are rising slowly, and the share of adults with jobs has not climbed since the recession.

A variety of indicators suggest the American economy may now be growing more quickly than analysts predicted, and Fed officials anticipate somewhat faster growth in the coming year. But the persistence of low inflation indicates the economy is operating well below its capacity.

Prices increased only 0.7 percent during the 12 months ending in October, according to a Commerce Department index that is the Fed’s preferred gauge of inflation, well below the 2 percent pace the Fed considers healthy. Economic projections by Fed officials, also published on Wednesday, showed that the officials did not expect inflation to exceed 2 percent in the next three years.

In beginning its retreat, the Fed said that it expected inflation to slowly increase in coming years. But it also made clear, for the first time, that it did not intend to raise short-term rates until prices actually started to rise. In doing so, it joins a growing list of central banks grappling with the novel challenge of trying to drive up inflation after decades spent trying to drive it down.

“The committee is determined to avoid inflation that is too low, as well as inflation that is too high,” Mr. Bernanke said at the news conference.

Some analysts saw an inconsistency between that rhetoric and the Fed’s shift, however.

“The Federal Reserve essentially disregarded the trajectory of inflation in this decision,” wrote Tim Duy, an economist at the University of Oregon.

Over the last year, the Fed has bought more than $1 trillion in Treasury and mortgage-backed securities in its effort to encourage job creation. Fed officials say the purchases have modestly reduced a range of borrowing costs, contributing, for example, to a rise in auto sales and an improving housing market. They say the program has also helped to revive an appetite for taking risks, driving up stock prices.

“The ripple effects go through the economy and bring benefits to, I would say, all Americans,” Ms. Yellen said at her confirmation hearing last month.

But independent analysts have struggled to isolate the effects of the program. Some Fed officials, and outside analysts including some at the International Monetary Fund, also see evidence that the impact of the bond buying has diminished as markets have returned to normalcy. Officials are increasingly concerned as well about the potential consequences, including the disruption of financial markets and the difficulty of unwinding the program.

Fed officials also are frustrated that the bond-buying program has become a source of financial instability as investors hang on every shift in policy. Those concerns were reflected in the Fed’s decision to announce not just an initial cut in bond buying, but a probable timetable for ending the purchases completely.

The policy shift won the support of Esther L. George, the president of the Federal Reserve Bank of Kansas City, who has dissented at each previous meeting this year over concerns that the Fed was doing too much. But with the balance swinging in favor of her views, the decision drew a dissent from Eric S. Rosengren, the president of the Federal Reserve Bank of Boston, who called it premature.

The decision won broad support from the policy-making committee, including most proponents of the overall stimulus campaign, because of the accompanying decision to strengthen the Fed’s commitment to holding down interest rates.

Wednesday’s announcement went well beyond the previous declaration of an intent to keep rates near zero at least as long as the unemployment rate remains above 6.5 percent. The Fed said instead that “it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6 1/2 percent, especially if projected inflation continues to run below the committee’s 2 percent longer-run goal.”

Some economists doubt the power of such guidance, however, including Stanley Fischer, whom the White House plans to nominate as Ms. Yellen’s vice chairman. Another critic of forward guidance, Adam Posen, president of the Peterson Institute for International Economics and a former central banker at the Bank of England, described the “fine-tuning” in a Twitter message as “not-so-fine policy.”

Stock prices fell earlier in the year when the Fed first talked about tapering, and the Wall Street economist Henry Kaufman of Henry Kaufman and Company was among the many who predicted a similar reaction once the Fed began to carry it out.

On Wednesday afternoon, he said that the Fed had succeeded instead in focusing the attention of investors on its forward guidance. “The market has concluded that the key issue is the level of short-term interest rates,” he said. “That will allow the market to continue to be aggressive risk-takers, to make speculative investments.”

Both the Standard & Poor’s 500-stock index and the Dow Jones industrial average reached new highs, without adjustment for inflation, with the Dow rising 292.71 points, or 1.8 percent, to close at 16,167.97, and the S.&P. 500 rising 29.65 points, or 1.7 percent, to 1,810.65. The Nasdaq composite index advanced 46.38 points, or 1.2 percent, to 4,070.06.

At the same time, the assurance that rates would remain low soothed bond investors. The yield on the Treasury’s 10-year note rose to 2.89 percent from 2.84 percent late on Tuesday, while its price fell 16/32, to 98 24/32.