Federal Reserve Chairman Ben S Bernanke may keep reinvesting maturing debt into Treasuries to maintain record stimulus even after making good on a pledge to complete $600 billion in bond purchases by the end of June.
The Fed chief’s top two lieutenants said this month the economy and inflation are too weak to warrant the start of a monetary-policy reversal. Investors and economists including David Kelly at JPMorgan Funds see that as a signal the Fed will keep its balance sheet at current levels by replacing about $17 billion a month in maturing mortgage debt with Treasuries.
Ending the reinvestment policy and the $600 billion program at the same time would be like quitting stimulus “cold turkey,” said Kelly, who is based in New York and helps oversee $400 billion as chief market strategist at JPMorgan. “It does make sense to reinvest for a while,” he said. “Then they could watch how bond yields react to that.”
Yields on 10-year Treasuries declined to 2.49 per cent from 2.76 per cent in the two weeks following the Fed’s Aug. 10 decision to begin reinvesting payments on assets purchased during the first round of bond buying from December 2008 until March 2010. An end to the reinvestment policy should be seen by investors as the first step in a tightening of credit by the Fed, said Neal Soss, chief economist at Credit Suisse Group AG.
Debate Starts
Fed officials are starting to debate what steps to take after completing the purchases, a program dubbed QE2 for the second round of quantitative easing. Policy makers were divided at their last meeting on March 15, with a “few” officials saying tighter credit may be warranted this year, while a “few others noted that exceptional policy accommodation could be appropriate beyond 2011.”
Janet Yellen, the Fed’s vice chairman, said April 11 that surging commodity costs over the past year are “unlikely to have persistent effects on consumer inflation or to derail the economic recovery and hence do not, in my view, warrant any substantial shift in the stance of monetary policy.”
William C. Dudley, president of the Federal Reserve Bank of New York and the FOMC’s vice chairman, said April 1 that the recovery is “still tenuous,” while Bernanke said April 4 that higher commodity prices may have just a “transitory” effect on inflation.
Bernanke last month identified ending the reinvestment policy as one of the Fed’s tools for exiting stimulus and draining reserves from the financial system.
‘Tone’ of Indicators
The Fed chief may be asked how long the reinvestment policy will be maintained in a press conference April 27, and “he’ll probably say that will depend upon the tone of the economic indicators in the months ahead,” said James Kochan, who helps manage $231 billion as chief fixed-income strategist at Wells Fargo Fund Management LLC in Menomonee Falls, Wisconsin.
“The first step is to end QE2,” Kochan said. “The next step will be to stop reinvesting the proceeds from the portfolio. I don’t know when that’s going to happen, but maybe around the turn of the year.”
The FOMC decision in August to start the reinvestment program initially fanned investor anxiety that the recovery would falter. Bernanke said later that month the policy was aimed at keeping borrowing costs low and that the Fed was weighing more securities purchases, a move announced on Nov. 3.
Yields Rise
Since then, yields on 10-year Treasuries increased to 3.38 percent as of yesterday from 2.57 percent. The Standard & Poor’s 500 Index gained 9 percent, while the dollar weakened by 1.3 percent against an index of six currencies.
Ten-year yields touched the lowest level in three weeks even after Standard & Poor’s yesterday lowered the outlook on its AAA rating for long-term U.S. debt to negative.
Most of the 50 analysts in a Bloomberg News survey last month expected the Fed to keep its bond portfolio stable for some time after the purchases end, with a plurality of 16 betting on a period of four to six months. Five economists said the Fed would halt the policy once QE2 ends; 11 said it would keep reinvesting for one to three months; 14 said seven to nine months, and four said more than nine months.
“If necessary, the Federal Reserve can also drain reserves by ceasing the reinvestment of principal payments on the securities it holds or by selling some of those securities in the open market,” Bernanke said in semiannual monetary-policy testimony before the House and Senate on March 1 and March 2.
Federal Reserve Bank of Philadelphia President Charles Plosser, part of a minority of policy makers who favor a tougher approach to controlling inflation, said in a March 25 speech that ending reinvestment is one of the first steps in his preferred exit method.
‘Headwinds’ to Growth
“Headwinds” against U.S. growth, including higher gasoline prices, reduced spending by state and local governments and a housing industry that’s “flat on its back” make it difficult for Fed officials to end the reinvestment policy, former Fed Governor Lyle Gramley said.
“The economy has a lot of problems,” said Gramley, now senior economic adviser with Potomac Research Group in Washington. “If I had to call the shots today, I would say continuing to reinvest the proceeds from maturing issues is better than a 50-50 chance.”
Extending the policy in the coming months would mean that a later decision to end it would signal the Fed’s broader exit from near-zero interest rates, said Soss, based in New York.
“It wasn’t a package deal at the beginning, and I don’t think that it’s a package deal at this juncture,” said Soss, who worked as an aide to former Fed Chairman Paul Volcker. “An announcement about not reinvesting would be a new policy innovation and undoubtedly should be viewed as the first move in a tightening program.”
