Taper on tap, sweeteners at ready: James Saft

November 21, 2013

Nov 21 (Reuters) – If you want to know what Janet Yellen
will do as Fed chair, ignore her congressional testimony and
watch Ben Bernanke’s lips.

Yellen, approved Thursday by the Senate Banking Committee,
will get the job, but the real action is in speeches by
Bernanke, who is less inhibited as he is on the way out, and in
the Fed minutes, released Wednesday.

Here is how it is going to go: The Fed will taper, probably
early next year, and will try to grease the skids by offering
some kind of forward guidance to ease the pain. A bit of
fiddling with the interest rate paid by the Fed to banks on
reserves is possible too, but a lot less likely.

Forward guidance is fancy central banker talk for making a
sort of a promise, or pledge, to keep rates at a particular
level in the future if particular conditions prevail. In this
case, the forward guidance will probably be to keep rates near
zero until unemployment falls below the current trigger level of
6.5 percent, perhaps as low as 5.5 percent.

“Even after unemployment drops below 6.5 percent … the
Committee can be patient in seeking assurance that the labor
market is sufficiently strong before considering any increase
(in the fed funds rate),” Bernanke said in a speech this week.

As for the why, no one is being that specific, but it looks
as if Federal Reserve officials are a bit in doubt about bond
buying’s efficacy while having some concerns about its attendant
risks.

Bond buying, Bernanke said, has “drawbacks not associated
with forward rate guidance, including the risk of impairing the
functioning of securities markets and the extra complexities for
the Fed of operating with a much larger balance sheet.”

The Fed is concerned that its pre-taper communications this
summer were incorrectly read, with many investors seeing the
move as a tightening in monetary policy. That seems to be behind
the idea of pairing a tapering with stronger forward guidance.
The Fed hopes it will dull any market effects of the taper,
effectively allowing a low-friction way for the central bank to
back slowly away from bond buying.

One other possibility is that the Fed will also make
adjustments to the interest it pays on reserves, potentially
keeping open some facility to allow it to pay less to banks for
the money they keep on deposit while not gumming up the vital
money market system.

One advantage of this is that it represents an actual
action, rather than simply a promise. That said, it is not
likely in itself to have a profound effect on bank behavior.

A FEW LOCAL DIFFICULTIES

So, tapering with a sweetener, but probably not until March.
While Bernanke will hold a press conference after the December
FOMC meeting, he may well wish to defer the decision, and the
explanation, to his successor.

Yellen will have to live with the program, and as forward
guidance is all about effective communication, it makes good
sense to allow her to be present and in control when it is
paired with tapering.

There are, of course, a few small problems with the whole
plan.

The Fed worries that, as when it promised to taper last
time, markets will see this as a tightening. They hope forward
guidance will work to keep rates low even as they stop buying
the bonds. Markets tightened, sending long rates higher, not
simply because they didn’t understand the Fed but because they
gave precedence to what the Fed was going to do – buy fewer
bonds – over what it said it wanted to see.

The point of QE isn’t simply to push people into taking on
risk and spending some of their paper gains, it is to make the
price of securities with more risk attached rise. The reverse of
that implies higher rates for riskier securities, including
longer-dated bonds.

Moreover, the whole premise of forward guidance is that
central bankers will say something and markets take them at
their word. That’s nice in theory, but in practice investors
understand that the woman making the promise today is a
different one than will be called upon to honor it in a couple
of years’ time.

Asked to weigh the value of real dollars going to buy real
bonds versus verbal promises about future states none of us can
truly know I am betting that markets give primacy to the money,
not the pledge.

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