Bernanke Must Reassure ‘Confused’ Market About Rate StrategyBy Rich Miller and Michael McKee

June 22 (Bloomberg) — Chairman Ben S. Bernanke has to convince investors the Federal Reserve can take back more than $1 trillion it pumped into the U.S. banking system to pull the economy out of the longest decline in more than six decades.

Bernanke and his colleagues, who meet June 23 and 24 to map monetary strategy, have said they need to continue buying assets and keep interest rates low for a long time to help revive growth. Rising Treasury bond yields show Wall Street is concerned their policy may lead to an inflationary bubble: Ten- year notes reached an eight-month high of 3.95 percent June 10.

“The markets don’t understand the Fed’s exit strategy; they’re confused,” said Lyle Gramley, a senior economic adviser with New York-based Soleil Securities Corp. and former central- bank governor. “That’s contributed to the rise in long-term rates.”

The risk is that higher rates will hold back the budding economic recovery by lifting borrowing costs for homeowners and buyers. Economists surveyed by Bloomberg forecast growth of 0.5 percent in the third quarter after gross domestic product shrank for four consecutive quarters — the first time that’s happened since 1947.

“It’s not good for the economy,” said Michael Feroli, a former Fed official who’s now an economist at JPMorgan Chase & Co. in New York. “It pushes back the housing rebound.”

The yield on the 10-year Treasury note ended trading at 3.78 percent June 19, up from 2.21 percent at the end 2008.

Rising Mortgage Rates

The average 30-year mortgage rate rose to 5.59 percent earlier this month, the highest since November, before slipping to 5.38 percent in the week ended June 18, according to Freddie Mac, the McLean, Virginia-based mortgage-finance company.

Mortgage applications dropped 16 percent in the week ended June 12 to the lowest in seven months, according to Mortgage Bankers Association data, as the jump in rates discouraged refinancing. Confidence among homebuilders fell unexpectedly in June, based on the National Association of Home Builders/Wells Fargo index, after U.S. foreclosure filings compiled by RealtyTrac Inc. surpassed 300,000 for the third straight month in May.

Yields on AAA-rated, 10-year general-obligation municipal bonds rose to 3.49 percent on June 12, the highest since March, before falling to 3.45 percent on June 19, according to Municipal Market Advisors in Concord, Massachusetts.

While investor optimism about the economy may be contributing to higher yields, there are still worries about the record $1.8 trillion budget deficit, along with the concern about the Fed’s plans, Gramley said.

Contain Costs

In an effort to contain borrowing costs, Fed officials are considering using the policy statement issued after this week’s meeting to try to suppress any speculation they’re prepared to boost interest rates as soon as this year.

If policy makers are going to restrain rates, investors and analysts say they should explain how they will cut the central bank’s balance sheet and prevent inflation from accelerating.

“Exit strategy is on everyone’s mind,” said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. “People are worried about the future.”

European Central Bank officials have also begun talking about how to reverse their stimulus. The ECB, which cut its benchmark interest rate to a record low 1 percent, is buying only 60 billion euros ($83.6 billion) in securities and said it will lend banks money for up to 12 months.

The loans will expire or banks will borrow less as the economy recovers, making it easier for the ECB to exit, said Nick Kounis, chief European economist at Fortis Bank Nederland Holding NV in Amsterdam.

Accelerating Inflation

In the U.S., concern is growing that consumer-price inflation will accelerate, based on trading in Treasury Inflation Protected Securities. Expectations for 2015 to 2019 — the so-called five-year, five-year-forward rate calculated by the Fed — increased June 2 to 3.18 percent, the highest since November, before sliding to 2.68 percent on June 16. The average since 2005 is 2.66 percent.

Behind investor unease is a $1.2 trillion jump to $2.07 trillion during the past year in the portfolio of mortgage, Treasury and other securities the Fed owns, as it flooded the banking system with reserves. The balance sheet rose to a record $2.31 trillion in December and has fallen since as the financial crisis eased and banks’ demand for short-term credit ebbed.

Meanwhile, the Fed is adding to its holdings of long-term securities, pledging to buy this year as much as $1.25 trillion of mortgage securities, $200 billion of agency debt and $300 billion of long-term Treasuries.

Stimulus Program

The purchases have come as the government embarked on a $787 billion stimulus program to boost the economy. Bernanke, 55, denied on June 3 that the Fed was helping to fund the deficit by buying Treasuries.

Anxiety over the Fed’s pump-priming program is twofold, according to Robert Eisenbeis, chief monetary economist at Cumberland Advisors in Vineland, New Jersey. The first worry is the central bank lacks the tools to unwind its monetary stimulus quickly enough. The second is that even if it can act in time, it won’t because of political opposition to tightening credit when unemployment is 9.4 percent, a 25-year peak.

“At some point they’ve got to start talking realistically about what the exit strategy is going to be,” said Eisenbeis, a former director of research for the Federal Reserve Bank of Atlanta. “All we’ve seen is a list of what they might do and no discussion of the practicalities and the politics.”

‘Small Portion’

Bernanke has argued that a substantial portion of the Fed’s assets are short-term and thus can easily be allowed to expire. Only a “small portion” of its longer-dated assets, such as mortgage bonds, might be sold at first, he said in a Jan. 13 speech. Instead, the Fed is counting on a new tool — the power to pay interest on the money banks deposit with it — to soak up liquidity left in the system.

“Interest on reserves is an important part of the exit strategy,” Fed Vice Chairman Donald Kohn said on May 23.

The Fed would raise that rate, now at 0.25 percent, to induce banks to leave money with it rather than lend to consumers and companies.

That move, coupled with an increase in the federal funds rate on overnight loans between banks, would cause borrowing costs to rise, capping inflation, according to Marvin Goodfriend, a professor of economics at Carnegie Mellon University in Pittsburgh and a former director of research at the Richmond Fed who has studied the use of interest on reserves. The current target for the federal funds rate is 0 percent to 0.25 percent.

Excess Cash

So far, the power to pay interest, which Congress gave the central bank in October, hasn’t worked as well as policy makers planned. Financial institutions that can’t deposit money with the Fed, including Freddie Mac and Washington-based mortgage- finance company Fannie Mae, have ended up with excess cash they’ve used for loans, pushing rates down.

“It hasn’t been a totally effective floor” for interest rates, Kohn said in May, while arguing that it will work better in the future as strains in the banking system ease.

Allan Meltzer, a Carnegie Mellon professor who has written a history of the Fed, said it won’t be able to raise the rate enough to contain inflation because Congress will oppose tighter credit while unemployment is high. Fed forecasts, which will be updated at this week’s meeting, show the jobless rate at 9 percent to 9.5 percent in the fourth quarter of next year.

“Without some more clarity on the Fed’s exit strategy, some people think this back-up in interest rates is going to create problems for housing and refinancing of mortgages,” said Richard Berner, co-head of global economics for Morgan Stanley in New York. “And it could.”

To contact the reporters on this story: Rich Miller in Washington rmiller28@bloomberg.netMichael McKee in New York at mmckee@bloomberg.net

Last Updated: June 21, 2009 19:01 EDT
from bloomberg.com 6-22-2009