The supertanker being steered by the US central bank looks destined to make big waves. The Federal Reserve's policy-setting committee showed no signs after its meeting this week of scaling back $85 billion of monthly bond buys and says there would be a big gap between ending purchases and raising rates. Yet, its 2015 target of up to 4.5 per cent is a far cry from a long stint near zero. The rapid turn could shock the system.
During his press conference on Wednesday, Fed Chairman Ben Bernanke said the amount of Treasury and mortgage debt the central bank purchases could be varied according to the strength of the economy. So far, though, five months - to February - of job creation over 200,000 hasn't warranted a reduction. Bernanke also expressed concern that fiscal tightening would slow output, citing a Congressional Budget Office estimate that measures enacted so far could knock 1.5 percentage points off GDP growth.
Meanwhile, the Federal Open Market Committee expects "a considerable time" to elapse after asset purchases are terminated before interest rates start rising. Indeed, only five of the committee's 19 members foresee any increase before the end of 2014. All but one, however, expect rates to start moving up by the end of 2015. The trajectory, in some cases, is quite aggressive. The mean outlook for December 2015 tallies at 1.35 per cent, though individual members anticipate short-term rates as high as 4.5 per cent.
By then, the federal funds rate will have been virtually nil for over six years, and if the Fed keeps buying at this pace, its balance sheet could surpass $4 trillion. FOMC members are forecasting growth to be fairly robust and inflation at around two per cent. That suggests negative real interest rates may push up the prices of equities and other assets further. After such a lengthy period of ultra-cheap borrowing, the expected gap between short- and long-term rates will be deeply baked into the operations of many banks and other institutions.
Put it all together and a relatively rapid tightening easily could cause damaging financial ripples. Preparing the market, for example by winding down asset purchases sooner rather than later, would be a way to navigate a somewhat smoother course.
