The Fed wants to go on ‘autopilot’: Look out for storm clouds ahead


If Janet Yellen has her way, the Federal Reserve that she chairs is about to go from the center of the market’s universe to a mere afterthought.

Investors might even welcome a boring Fed after a decade of hanging on every word out of the central bank. But for Yellen’s hope to become reality, a whole lot of things will have to go right.

First, the economy will have to continue to strengthen. Then, not only will growth have to pick up but inflation also will need to meet what looks like an increasingly ambitious Fed target of 2 percent growth. Finally, the unwinding of the Fed’s $4.5 trillion balance sheet, an unprecedented move in central banking history, will have to go off pretty much without a hitch.

Though Yellen and her cohorts have defied their critics’ skepticism before, this time could be tougher.

“They desperately want this to be an easy, smooth, paint-drying type of process, but there’s no chance,” said Peter Boockvar, chief market analyst at The Lindsey Group. “The whole purpose of quantitative easing was to inflame the markets higher. Why shouldn’t the reverse happen when we do quantitative tightening?”

The policymaking Federal Open Market Committee on Wednesday delivered an expected quarter-point hike in its benchmark interest rate target, but surprised in another respect. Yellen and the FOMC detailed the planned unwinding of the balance sheet, or the portfolio of bonds and agency debt the central bank acquired during three rounds of easing.

During her post-meeting news conference, Yellen specifically referred to the balance sheet program as “watching paint dry,” attributing the quote to Philadelphia Fed President Patrick Harker.

“This will just be something that quietly runs in the background. That’s my expectation and our intention,” Yellen said. “Of course, if it turns out there is a surprise, a substantial reaction, that is something that we would have to take into account when deciding the appropriate stance of policy.”

Some in the market took that to mean that after nearly a decade of data dependence, the Fed is now effectively switching to autopilot. Interest rates would increase at a regular basis, and the balance sheet will decline at a pace the Fed outlined in the FOMC statement — a gradual work-up to $50 billion a month until the portfolio reaches what officials see as an appropriate level.

Observers wonder if it can all be that simple.

‘Autopilot’ may not go smoothly

“The third rate hike in seven months, coming not long after a relatively poor [reading on first-quarter GDP], suggests the Fed has become less data dependent in its monetary policy decisions,” Brian Coulton, chief economist at Fitch Ratings, said in a note, one in a flurry of missives from other experts who weighed in on the Fed’s moves.

“The objective here is to pre-announce plans so that the run-off of assets happens on ‘autopilot,'” he added. “But with the Fed committing to offload $600 billion of bonds to the market per year, the reality is that they are beginning to dismantle the framework of exceptional monetary support.”

Government bond yields moved higher Thursday in the wake of the rate hike — as they should. But traders remained skeptical over whether the Fed would be able to pull off the monetary scheme.

A September rate hike stands just an 18 percent chance, and December is less than a coin flip at 49 percent, according to the CME. A likely scenario, according to many Fed watchers, is the beginning of the balance sheet reduction in September, followed by a rate increase in December.

The balance sheet operation is significant because it will push more bond supply into the public markets and likely drive up interest rates as well. The Kansas City Fed estimates that each $675 billion reduction in the balance sheet would equate to one rate hike, so that would mean about one more rate increase a year through the run-off operation.

“The open question coming out of the meeting is whether the Fed’s guidance is credible,” said Jeremy Lawson, chief economist at Standard Life Investments. “The initial market reaction suggests that markets are doubtful.”

The Fed wants to raise rates and reduce the balance sheet because it is looking to normalize policy after a prolonged period of extreme measures. Both instruments were used to bring the economy back from the brink during the financial crisis, but critics charge that the Fed has kept up the accommodative policies for too long and is risking asset bubbles and not having tools left to ease should another downturn hit.

However, there are also those saying that not only has the Fed waited too long, but it also shouldn’t be hiking now with inflation so low.

Much of Yellen’s news conference focused on questions about low inflation, but Fed officials believe it is not much of a concern. The Yellen coalition advocates something called the Phillips curve, which indicates that low unemployment — the current rate is 4.3 percent — eventually will push income higher and drive inflation.

Yellen “again tried to drive home that it’s important not to overreact to recent inflation prints and that with the labor market tightening the pieces are in place for inflation to firm. Yet again, this is the Philips curve argument,” said Tom Porcelli, chief U.S. economist at RBC. “We sigh when we think this is a critical factor for the Fed, but they believe in it and ultimately that’s what matters.”

Indeed, some market participants worry that a Fed on autopilot will miss some important signs along the way.

“Since World War II we’ve had 13 rate-hike cycles: 10 put us into recession,” Lindsey Group’s Boockvar said. “To think that there’s some sort of free lunch where they can normalize and let the balance sheet roll off and everything will be fine and dandy, I think there’s some delusion to that.”

Source: CNBC

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