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Analysis: Fed mulls adjusting its tune to quell jittery markets

A trader looks up at a chart on his computer screen while working on the floor of the New York Stock Exchange shortly after the market openi
A trader looks up at a chart on his computer screen while working on the floor of the New York Stock Exchange shortly after the market openi

By Ann Saphir and Jonathan Spicer

(Reuters) - Federal Reserve officials are considering moving the goal posts on U.S. monetary policy with a promise to keep interest rates low for longer in the hopes of heading off a troubling rise in market-set borrowing costs.

Top Fed officials, who have pulled out all the stops to boost the U.S. recovery from recession, have worried for months that investors might drive bond yields up when the time came to reduce the central bank's bond-buying program.

Their fears have started to become reality. Yields, which move inversely to the price of Treasury debt, began to climb sharply in May with signs of stronger jobs growth and signals from the Fed that it could begin to scale back its bond purchases, known as quantitative easing, as soon as September.

With yields rising, some Fed officials warmed to the idea of anchoring borrowing costs more firmly by pledging to keep overnight rates near zero well after the jobless rate falls below 6.5 percent, the Fed's current threshold for considering tighter monetary policy. Unemployment stood at 7.6 percent in June.

Fed Chairman Ben Bernanke raised the prospect of a lower threshold for the jobless rate last month, but the message was lost in the din created when he said the central bank's policy-setting Federal Open Market Committee planned to halt the bond purchases by mid-2014 - a comment that sent bond yields soaring.

"I do think there are lot of FOMC members who would want to keep zero rates as long as possible, particularly during the QE exit," said Bluford Putnam, chief economist at futures exchange operator CME Group and a former New York Federal Reserve Bank economist. "So, they might argue down the road to change that 6.5 percent to 6.0 or something."

The president of the Minneapolis Fed, Narayana Kocherlakota, championed the idea nearly a year ago when he called for a 5.5 percent threshold for the jobless rate - and he hasn't backed down since.

Kocherlakota argued that if households and businesses believe the Fed will start jacking up rates when unemployment is still well above what most economists consider healthy, borrowing, spending and hiring levels would be lower than what they would if they think the Fed will wait until the job market returns to normal.

The current promise, and Kocherlakota's proposal for a lower threshold, come with an important safeguard: if inflation threatens to rise above 2.5 percent, the Fed says, rates could go up even if unemployment is still high.

EYES ON INFLATION, JUMPY MARKETS

Officials privately say the option to lower the unemployment threshold is on the table but not a sure thing.

But the recent moves in the bond market make the option all the more attractive. The yield on the 10-year Treasury note, which is used as a benchmark for mortgages and other borrowing rates, has climbed about a percentage point over the past two months.

Before they sign on to a change, officials may want to see persistently low inflation that could signal the risk of growth-sapping price declines and a stalling economy, or fear another damaging rate rise in response to changes to the bond-buying program.

The table is set for both. When the Fed's 19 officials released their latest economic forecasts last month, not a single one believed that inflation would rise above 2.5 percent before unemployment falls below the 6.5 percent marker.

But when Bernanke's June 19 comments on the end of bond buying sparked a global stocks and bonds selloff, some colleagues in the following days tried to talk down yields, suggesting that they are very sensitive to sharp changes in market expectations, especially those that threaten to undo the labor market progress made so far this year.

William Dudley, the influential head of the New York Fed who was among seven central bank policymakers who spoke in the week after Bernanke's comments, went so far as to say that market expectations for a rate hike were "quite out of sync" with the Fed's expectations.

The recent chatter from the Fed, including dovish comments from Bernanke on Wednesday, has seemed to work: yields on 10-year Treasuries have fallen back and stocks have climbed, with the S&P 500 close to record territory on Thursday.

But traders of futures that track the Fed's key policy rate only hardened their conviction that the final quarter of 2014 will mark the end to what would then be about six years of near-zero overnight interest rates.

That is at odds with a full 14 of the central bank's 19 policymakers who don't expect to raise rates until some time in 2015, based on June forecasts.

HALT QE... THEN RAISE RATES

Bernanke's comments on Wednesday were seen as a fresh effort to jawbone markets. He renewed his message that policy would remain "highly accommodative" and rates could well stay low even after the jobless rate falls below the current threshold.

"There will not be an automatic increase in interest rates when unemployment hits 6.5 percent," he said.

But simply repeating the Fed's pledge to keep rates low or even postponing any cuts to the bond-buying program may fail to convince the public that a rate rise in 2014 is unlikely, said Jan Hatzius, chief U.S. economist at Goldman Sachs.

A "more promising" way to halt the bond selloff would be to lower the jobless rate threshold. Doing so could help stabilize expectations if Bernanke steps down as expected when his current term expires in January and the reins go to a new Fed leader whose views might not be as well known.

It would also "signal to the markets that the Fed's 'character' hasn't really changed and the earlier taper is more of a change to monetary policy tactics as opposed to strategy," Hatzius wrote in a client note earlier this week.

Bernanke made that point on Wednesday, saying that a "gradual and possible change in the mix of instruments," including bond-buying and rate policy, "shouldn't be confused with the overall thrust of policy, which is highly accommodative."

Policymakers' main problem appears to be convincing investors the first rate rise is not likely to come mere months after QE is halted, as the market seems to predict. Instead they want to drive home the point they are willing to wait as long as a year or even more before tightening, depending on the economy's strength.

Still, the argument for lowering the unemployment threshold is far from won.

The president of the San Francisco Fed. John Williams, told reporters last month that 6.5 percent is a "reasonable" level at which to consider raising rates, given that it can take months before a change in monetary policy affects the economy.

Even so, he suggested the idea is open to debate.

"I think these are exactly the kind of discussions we should be having," he said. "As we get closer (to the threshold) we are going to need to recalibrate our communications to make these points more clearly."

(Reporting by Jonathan Spicer and Ann Saphir; Editing by Leslie Adler)

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