Wednesday, June 17, 2009

Fed Weighs Using FOMC Statement to Damp Rate-Rise Speculation

Federal Reserve officials are considering whether to use next week’s policy statement to suppress any speculation they’re prepared to raise interest rates as soon as this year.

While policy makers have signaled they accept an increase in longer-term Treasury yields as the economy improves, some are concerned at any premature anticipation of rate rises. Fed staff have examined the Bank of Canada’s public intention of foregoing an increase until 2010, according to a person familiar with the matter, without concluding the statement has proven effective.

One option would be to emphasize in the June 24 statement that increasing slack in the job market and U.S. manufacturing will keep inflation low and a recovery muted, said Michael Feroli, an economist at JPMorgan Chase & Co. in New York and former member of the Fed Board staff. At stake: keeping borrowing costs low enough to foster a sustained recovery, without binding the central bank to a single course of action.

“There are ways of highlighting their low rate expectations without over-committing,” said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey.

Chairman Ben S. Bernanke and his fellow Federal Open Market Committee members gather in Washington June 23-24. Economists forecast they will keep their target for the benchmark federal funds rate at zero to 0.25 percent. Policy makers will also discuss any changes to their commitment to purchase as much as $300 billion of Treasuries and $1.45 trillion of housing debt.

‘Extended Period’

In its past two statements, the FOMC has said “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

Markets have signaled they’re no longer heeding that language. Two-year Treasuries have slid since a June 5 government report showed the smallest decline in payrolls in eight months, with the notes yielding 1.18 percent late yesterday, up from 0.91 percent at the start of the month.

Federal funds futures contracts for March carry a yield of 0.765 percent, indicating some probability of a rate boost by the first quarter of 2010.

While job losses are slowing, Fed officials have repeatedly warned that the unemployment rate is likely to climb for months to come. President Barack Obama said yesterday in a Bloomberg Television interview he anticipates the rate will reach 10 percent this year, from 9.4 percent in May.

New Forecasts

Fed governors and district-bank presidents will bring a fresh round of economic forecasts to the central bank’s boardroom next week. They are likely to raise their unemployment forecast from a previous projection of 9 percent to 9.5 percent for the fourth quarter of next year, analysts said.

Enhancing the statement with details on their latest views on inflation and joblessness might be the best way to back markets down from expected rate hikes. JPMorgan Chase estimates that labor-market slack won’t disappear until the unemployment rate drops to around 6 percent.

“How do you get people to believe what you have been saying?” Feroli said. “You say you are going to have a very large output gap for an extended period,” and even if the economy picks up “you still have a massive resource gap in the labor market.”

An output gap is an estimate of the difference between the economy’s potential to grow given resources such as labor and manufacturing capacity and its actual growth rate. The estimate figures into Fed calculations about future inflation.

Increasing Slack

Underscoring the still-increasing slack in the economy, the Fed yesterday reported that the share of the nation’s industrial capacity in use dropped to a record low of 68.3 percent in May.

“They need to put something in writing in the statement related to the way they see the economic outlook,” said Stephen Stanley, chief economist at RBS Securities Inc. in Stamford, Connecticut. “The level of activity is still very low, and inflation will be benign for the foreseeable future.”

Longer-term Treasury yields have risen even more than those on short-term securities, an indication some investors are anticipating faster gains in consumer prices. Fed officials have signaled they’re comfortable with the increase so far.

“The economy is doing better and less worse than it was before; I am not surprised to see rates back up,” Dallas Fed President Richard Fisher said in a June 15 interview with Bloomberg Television. “There is so much slack in the system,” he also said. “The idea of tightening from where we are -- I don’t see it in the immediate future.”

Bernanke History

Bernanke was a proponent of using statement language to tether short-term rate expectations when he was a Fed governor in 2003. Then-Chairman Alan Greenspan introduced the phrase “considerable period” in August of that year to put a time commitment on the existing 1 percent rate target.

Bernanke supported Greenspan in a debate over the phrase at the August meeting: “The addition of the sentence will go some way to bringing policy expectations in the market toward what I heard around the table during the entire meeting today,” he said, according to an FOMC transcript.

The Bank of Canada recently took time commitment a step further. On April 21, the Canadian central bank reduced its key rate to 0.25 percent, the lowest in its history, and said that “conditional on the outlook for inflation, the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010.”

A calendar commitment isn’t likely to prove popular with all Fed officials, because some want to maintain flexibility to reverse the central bank’s record balance-sheet expansion in excess of $1 trillion over the past year.

“Part of rightsizing will be to decide where boldness ends,” Charles Evans, president of the Chicago Fed and voting member of the FOMC, said June 15.