Federal Reserve

Fed Prepares for Change in Policy, and in Policy Makers

Binyamin Appelbaum
The Federal Reserve
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Federal Reserve officials, who have made clear that they intend to cut back on the Fed's monthly asset purchases by the end of the year, must decide next week whether it is time to tap the brakes or better to wait another month or two.

The far thornier challenge they face is convincing markets that the Fed remains committed to its broader effort to stimulate the economy even as it begins to pull back from the most visible component of that campaign — and even though as many as nine of the 12 voting members of the Fed's policy-making committee may be replaced in the next year.

Most notably, Ben S. Bernanke, the Fed's chairman, is expected to step down at the end of January; the person President Obama is widely expected to nominate in his place, Lawrence H. Summers, has said little about monetary policy in recent years.

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Can the Fed make a significant taper?

Fed officials are concerned that the markets will misinterpret the introduction of tapering, as the impending move is popularly known, as a sign of a broader retreat. They are expected to discuss ways of reinforcing the Fed's continuing determination to encourage economic activity and job creation when the Federal Open Market Committee meets here Tuesday and Wednesday.

"The overwhelming incentive at this meeting is to dull the hawkish effects of tapering with more dovish communication," wrote Eric Green, head of rates, foreign exchange and commodities research at TD Securities. The Fed's message, he said, "has been ill defined and not internally consistent. The good news is that the F.O.M.C. has the opportunity to improve on that message."

The Fed under Mr. Bernanke has struggled for much of the last five years to find new ways of stimulating the economy beyond its base-line commitment since December 2008 to hold short-term interest rates near zero.

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Last year, officials announced an aggressive combination of asset purchases and forward guidance, both tied to improvement in the labor market. The Fed said it would buy $85 billion a month in Treasury securities and mortgage-backed securities to jump-start job growth, and keep short-term rates near zero at least as long as the unemployment rate was above 6.5 percent. It was 7.3 percent in August.

In June, however, Mr. Bernanke surprised many investors by announcing that the Fed intended to reduce the volume of monthly purchases by the end of the year, and to end the purchases entirely by the middle of next year. An official account of the committee's most recent meeting in July affirmed that "almost all participants" favored Mr. Bernanke's timetable, provided that "economic conditions improved broadly as expected."

Investors have started to demand higher interest rates, driving up borrowing costs, and critics warn the Fed is pulling back too soon. The unemployment rate is down from 8.1 percent in August 2012, just before the Fed started the expansion of its bond portfolio. But roughly half the decline happened because more adults were not even trying to find jobs. The share of adults with jobs, down sharply during the recession, has yet to recover any of its losses.

Fed officials have emphasized in response that their policy decisions are forward-looking. Changes in monetary policy seep slowly through the economy — from the Fed through the banks into the decision-making of business and individual borrowers — and Fed officials have said they are convinced the economy will not need as much help in the next few years.

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Mr. Bernanke and his allies also face mounting pressure from internal critics who worry the modest benefits of asset purchases increasingly are outweighed by the risk that continued expansion of the Fed's holdings will disrupt financial markets — by encouraging speculation, by limiting the availability of some kinds of securities or by seeding inflation.

Many analysts predict that proponents of bond buying, also known as quantitative easing, will agree to cut the volume of monthly purchases initially by a small amount, perhaps as little as $10 billion.

"Concerns about the cost of Q.E. have reached a tipping point for the F.O.M.C., and Q.E. tapering will start even though the economic recovery remains tepid," wrote Kevin Logan, chief United States economist at HSBC Securities. Mr. Logan had predicted the change would happen in December, but said comments by Fed officials persuaded him September was more likely.

Making the case for Yellen to take Fed reins

A small reduction in bond purchases should have little economic impact, but investors took Mr. Bernanke's comments in June as evidence the Fed might begin to raise rates sooner than they had expected.

The Fed has sought to stimulate the economy by persuading investors to trust that rates will remain near zero for years to come. Inevitably, investors are skittish about any sign that the Fed may change its mind. And uncertainty about the Fed's plans has been compounded by the impending shake-up of the Fed's policy-making committee.

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Four of the 12 voters on the Fed's policy-making committee are replaced each year through a rotation of the presidents of the regional reserve banks. Unusually, as many as five of the seven governors may also be replaced.

Elizabeth A. Duke stepped down at the end of August. Sarah Bloom Raskin has been nominated as deputy Treasury secretary. Jerome H. Powell's term ends at the same time as Mr. Bernanke's, although the White House might decide to leave Mr. Powell, a Republican, in place. And Janet L. Yellen, the Fed's vice chairwoman, is seen as unlikely to remain if she is passed over in favor of Mr. Summers.

Fed officials have discussed a number of options to reassure investors. The Fed has said it intends to hold short-term rates near zero at least as long as unemployment remains above 6.5 percent and inflation remains under control. Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis, wants to reduce the threshold to 5.5 percent. Other Fed officials, seeking to preserve flexibility, prefer the softer approach of emphasizing that 6.5 percent is a threshold, not a target.

"I can easily envision certain circumstances in which the unemployment rate could go below 6 percent before we moved the funds rate up," Charles Evans, the president of the Federal Reserve Bank of Chicago, said in a speech earlier this month.

Esther George, president of the Federal Reserve Bank of Kansas City, suggested the Fed should address how quickly it expects to raise rates once that process begins, by estimating the level of future short-term rates.

"Markets and the public are likely having a difficult time understanding exactly how fast the F.O.M.C. is likely to raise interest rates after the first rate hike," she said.

By Binyamin Appelbaum of The New York Times