Fed Contemplates Winding Down Stimulus Spending

On January 13th, the Federal Reserve Beige Book revealed that 10 of the 12 districts surveyed by the Federal Reserve, experienced positive growth during the reporting period. Obviously emboldened by this news, calls for scaling back on stimulus spending and making a directed effort at soaking up the billions of dollars in “excess” cash within the US banking system have grown not only in intensity, but also in the number of Fed members advocating a policy change. This must be most welcome to Philadelphia Federal Reserve Bank President Charles Plosser who for the last year, has been the lone voice arguing for a tightening of the money supply to counter fears of rampant inflation as the economy enters the recovery phase.

2010 Federal Reserve Projections for the Economy

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In late November, the Fed issued a series of projections for 2010 outlining how the agency expects the year to unfold. For starters, the Fed pegged overall growth for the year to fall within a range of 2.5 to 3.5 percent, but it is the inflation projection – total growth excluding food and energy – that is the better metric for evaluating the recovery, and here, the Fed has predicted inflation to increase only between 1 and 1.5 percent.

This is actually a rather weak growth forecast and explains why the Federal Reserve’s employment outlook still has unemployment between 9.3 and 9.7 percent by the end of 2010. This is only a slight improvement over December’s 10 percent unemployment rate. Taking into account even the Fed’s best case scenario for growth then, we are still looking at just over half a percent improvement in employment.

Still, this is the most positive outlook for the economy in three years, so maybe it is time to start planning for a post-stimulus future as Federal Reserve Vice Chairman Donald Kohn hinted in his address to the American Economic Association a few weeks ago. During the group’s annual meeting, Kohn was asked what steps the Fed would take to de-couple the economy from government spending. Kohn replied that the Fed had “no shortage” of tools with which it could soak up liquidity within the banking system and the overall economy, noting that the “appropriate use and sequencing of these tools is under active discussion by the FOMC”. This immediately set me to thinking about these “tools” and what approach would be the most effective with respect to reducing cash levels within the economy, while still providing an appropriate environment for recovery and sustained growth.

The first thing that comes to mind of course, is a change in the interest rate policy. For almost two years now, the benchmark Federal Funds rate has been “zero bound” with a target range between zero and 0.25 percent. Maintaining this low rate was essential when the economy was shrinking at an alarming rate during the worst of the recession, but as growth returns, an assessment of the current Federal Funds rate is warranted.

When the Fed raises the bank lending rate, it expects a similar increase to trickle-down to the commercial rates thereby making consumer loans more expensive. This typically results in a reduction in consumer spending and an overall “cooling” of the economy, but herein lies the problem. Raising interest rates will indeed make credit more expensive, but consumers are not even close to returning to the spending habits they exhibited before the recession. Spending on big ticket items in particular – durable goods such as automobiles and appliances – remains very subdued and these are the sorts of things that usually require financing. This makes me question the effectiveness of increasing borrowing costs as a way to reduce liquidity in the economy when consumers are still gun-shy with respect to their debt levels and are not borrowing for non-essentials anyhow.

The other fear I have regarding an increase in borrowing costs in the near-term is the effect this could have on businesses trying to rebuild from the recession. In order to reduce costs, companies were forced to lay-off workers and put expansion plans on hold, but for those that managed to weather the storm, the goal now is to try to rebuild lost business. Access to inexpensive loans will be critical to the success of these endeavors and will be the first step in getting the unemployed back to work.

Speaking of unemployment, there is no question that this remains the number one concern for most Americans. The unemployment rate as of the end of December was pegged at 10 percent, but the “real” unemployment rate is surely double that. The other point to keep in mind is that employment lags changes in the economy and it takes several months for improvements in the economy to translate into an increase in employment.

This is something that Federal Reserve Chair Ben Bernanke obviously understands as evidenced by his pledge late last year to hold interest rates at an “extremely” low rate for as long as necessary for the economy and employment to recover.

“Most forecasters including the Fed are currently looking at growth in 2010, but not growth so rapid as to substantially lower the unemployment rate. Even with 3 percent annual growth, unemployment would still probably be above 9 percent by the end of 2010.”

– Federal Reserve Chair Ben Bernanke addressing the House Financial Services Committee, October, 2009

So let’s rule out an interest rate hike any time soon and look at other possible ways the Fed could remove liquidity from the banking system. Fed Vice-Chair Kohn has suggested the selling of Fed assets as an effective approach and this certainly has merit. The Fed’s balance sheet is currently a bloated $2.2 trillion built-up through the purchase of asset-backed securities as part of its quantitative easing program to inject cash into the banking system. If the economy is gaining momentum – and if there is now indeed an excess of cash in the banking system – then perhaps the need for further quantitative easing has passed and the time is right for the Fed to now sell these assets back to the financial institutions.

This would meet the goal of reducing the cash supply yet would leave interest rates at the low level as desired by Bernanke. Think of it as reverse quantitative easing.

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