Timing of Next Federal Reserve Move Crucial

It may be a long way off, but the when and the how are already a hot topic.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

June 24, 2009

Federal Reserve officials are still balancing on a policy tightrope. They’re promising to continue injecting credit into the economy. At the same time, they need to keep bond investors convinced that they’re ahead of the curve on ensuring that inflation pressures remain in check.

The central bankers will be doing the high-wire act for some time, and there’s no safety net. They do have some things working in their favor. For instance, durable goods orders have risen three out of the past four months, suggesting that the recession is near an end. That means they won’t have to keep credit loose and rates near zero for too long.

At the same time, unemployment is at 9.4% and continuing to rise while factory utilization remains at record low levels. Despite bond investors’ inflation fears, driven mostly by worries about the size of the government’s budget deficit, there’s little evidence that the recovery is going to be a blockbuster that would trigger an inflation surge.

The Fed’s June 24 statement acknowledged these opposing forces. The comments followed a two-day meeting of the Federal Open Market Committee, the Fed’s policymaking arm. They reaffirmed that the Fed’s benchmark short-term interest rate is staying unchanged near zero and repeated language from previous statements that the low rate will likely hold “for an extended period.”

The statement also gave a nod to bond investors who fear that inflation will be fueled by the massive bond sales needed to finance the soaring budget deficit. “The prices of energy and other commodities have risen of late,” the statement said. But “substantial resource slack” leads policymakers to believe that “inflation will remain subdued for some time.”

The Fed needs bond investors on its side to keep the recovery going. In the past month and a half, 10-year Treasury bond yields jumped nearly 1.5 percentage points, to almost 4%. The increase was enough to send 30-year fixed mortgage rates up about a half percentage point, which has curtailed mortgage refinancing. So far, sales of existing homes haven’t stalled. And in recent days, 10-year Treasury bond yields have fallen back to 3.7%, an encouraging sign.

“The challenge will come at the [Fed’s policymaking] meeting in September. By the time the committee meets on Sept. 22, we’ll see some growth in the economy, and there will be more pressure” on the Fed to at least begin talking about a shift in policy, says John Silvia, chief economist with Wachovia Corp.

There is evidence that the Fed’s policies so far are achieving the desired results. Keeping rates ultra low along with the Fed’s buying mortgage securities and other debt have persuaded many investors to return to what had been frozen up credit markets. Also, the stock market has risen some 35% since its low last March. But though financial markets “have pulled back from the abyss, we’re still at recession levels” right now, says JPMorgan Chase senior economist James Glassman. “We’re nowhere near healthy.”

And a number of policymakers at the Fed have recently given speeches suggesting that it’s not too early to be talking about a shift in policy to raising rates. “There is debate inside the Fed, and it’s going to continue,” says former Fed Governor Lyle Gramley.

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