The Fed is about to surprise investors

By Rick Newman 

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Federal Reserve Board Chairman Ben Bernanke arrives to testify on Capitol Hill in Washington, Tuesday, Oct. 4, 2011, before the Joint Economic Committee hearing on the economic outlook.

(AP Photo/Evan Vucci)

The main question this year about the Federal Reserve’s extraordinary easy-money policy has been when it will begin curtailing $85 billion in monthly purchases of bonds. If it doesn’t happen soon, at the end of the Fed’s in-progress mid-December meeting, the betting money is on a decisive move at the gathering in March.

But that binary set of options — "tapering" or not, to use Wall Street’s overworked term — is a vastly oversimplified view of the Fed’s options.
Many critics feel quantitative easing, as the Fed’s bond-buying policy is known, has failed to achieve its goal of jump-starting the economy and helping create jobs, even though the unemployment rate has fallen from a peak of 10% in 2010 to 7% today. Those folks would like to see the policy rolled back as quickly as possible, since it may be contributing to an overinflated stock market and other economic distortions.
However, the intense debate over the virtues of quantitative easing and the rollback schedule, whatever it turns out to be, has drawn attention away from other tools the Fed could use. "The Fed has many more options than any of us can contemplate," says Peter Fisher of investing firm BlackRock.
In fact, the Fed may introduce new "offsets" to soften the impact of a policy change at the same time it decides to tighten up on quantitative easing. Here are some of its alternatives:
Change its quantitative easing targets. The market presumption seems to be that once the Fed cuts back, it will reduce its $85 billion in monthly bond purchases by a similar amount each month — say, $10 billion — until they fall to $0. But it could also change the way it purchases bonds. The Fed could say it will purchase a fixed amount of bonds, for example up to $500 billion worth, but on no fixed schedule. Or, it could say it will buy bonds until some future deadline, such as the end of 2014, but not say how much.
The purpose would be to gradually tighten policy while still reassuring financial markets it intends to help the economy. Fine-tuning the amount of bond purchases and the exact timing would help send the desired message (if it worked).
Change the threshold for tightening. There are two key components to the Fed's easy-money policy: quantitative easing (which pushes long-term interest rates down) and low short-term rates, which the Fed controls directly with the fed funds target rate. The Fed has said it will keep short-term rates near zero until the unemployment rate hits 6.5% or lower, as long as inflation remains below 2%.
It could easily change either of those targets, or tie a policy change to other indicators, such as unit labor costs or the average length of the workweek, so the decision would be based on a fuller view of labor market conditions. Any move along these lines would be meant to signal the Fed will keep rates low for longer than currently expected, making for bullish news for borrowers and investors.
Lower the interest rate the Fed pays banks. Commercial banks have about $1.6 trillion in accounts at the Fed, which is paying them an interest rate of about 0.25%. That’s obviously very low, but in normal times, the Fed pays no interest on deposits. For banks, the ability to earn $2.5 million per year for every $1 billion on deposit at the Fed, with no real risk, has persuaded them to leave most of that money there.
If the Fed lowered its rate to 0%, banks would be more inclined to lend their money and pursue profit that way. That would risk higher inflation, since more money would be flowing into the real economy, but it would also generate more economic activity, since most borrowed money gets spent.
Provide clearer "forward guidance." One mistake the Fed made in 2013 was signaling that a policy change would be coming soon, which drove up rates in May and June, then reversing course, as the threat of an October government shutdown became more dire. The Fed, if it chose, could be much more specific and far less cryptic about its plans, by spelling out exactly what it plans to do, and when, instead of leaving everybody guessing. The tradeoff would be less flexibility to change its policy and lost credibility if it didn’t do what it promised.

Aside from the many technicalities of monetary policy, the Fed has the tricky job of trying to gauge the way markets are likely to react to any policy change, along with how much it matters. The Fed would never say this, but it's been deferential toward market sentiment during the last five years, perhaps because the central bank realizes that confidence or distrust in the economy can sometimes be as powerful as actual conditions. To some critics, that amounts to coddling, and it needs to end.

"The Fed wants to wind down purchases," says Alan Levenson, chief economist at investing firm T. Rowe Price. "It will start reducing asset purchases when it finds a way to strengthen interest rate guidance to soften the blow."

If you get the message the Fed most likely intends to send, you'll breathe a sigh of relief, hold onto your stocks and perhaps buy more. And whether you interpret the Fed's actions in a benign or alarmist way probably matters a lot more itself than when it is you do it.