Bloomberg News

Fed May Signal Balance Sheet Will Stay at Record Amid Slowdown

June 01, 2011

June 2 (Bloomberg) -- A wave of surprisingly weak data on the U.S. economy may spur Federal Reserve policy makers to support growth by making it clear they’re in no hurry to shrink the central bank’s record balance sheet.

There’s a “strong possibility” that the Federal Open Market Committee will say following the June 21-22 meeting that it will keep reinvesting proceeds from maturing debt for a while, said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York. Previously, the FOMC has said it will keep the benchmark interest rate near zero for an “extended period” without a similar pledge about its balance sheet.

Yesterday’s reports showing manufacturing grew at the slowest pace in more than a year in May and employers added fewer jobs than forecast prompted Feroli to cut his estimate for second-quarter economic growth. The slowdown may push policy makers to consider what options are left after their second $600 billion round of asset purchases sparked a Republican backlash. Saying the balance sheet won’t shrink immediately could dispel any notion that the Fed is about to push up borrowing costs.

“The idea of extending the period in which they maintain this level of accommodation is an easy call, a natural call and the right call,” said Neal Soss, chief economist for Credit Suisse Holdings USA Inc. in New York. A third round of asset purchases “is so contentious within the committee and the broader political environment, that they aren’t going to go there. That makes it very unlikely.”

2012 Outlook

Soss said he doesn’t expect any balance-sheet tightening until 2012 and no increase in the benchmark federal funds rate until the third quarter of 2012. Feroli sees the first rate increase in 2013.

Fed Vice Chairman Janet Yellen, in a Tokyo speech released late yesterday in Washington, said that “the current accommodative stance of U.S. monetary policy continues to be appropriate because the unemployment rate remains elevated and inflation is expected to remain subdued over the medium run.” She didn’t elaborate on her economic outlook or discuss the recent U.S. indicators.

The yield on the U.S. Treasury 10-year note dropped yesterday below 3 percent for the first time this year. It fell to 2.94 percent at 5 p.m. in New York from 3.06 percent on May 31. The Standard & Poor’s 500 Index tumbled 2.3 percent to 1,314.55, its biggest drop since August.

Traders are betting on the Fed to raise its target interest rate by August 2012, Fed funds futures contracts show. That compares with expectations for a December 2011 increase four months ago.

Portfolio Changes

A Bloomberg News survey in April found that 32 of 44 economists expected the Fed this year to halt its policy of keeping its portfolio level stable by replacing maturing mortgage-backed securities with Treasuries. Nine respondents saw that happening in June; 12 in the third quarter; and 11 in the final three months of the year.

“The most vulnerable moving part is when do they end the reinvestment of maturing securities,” said Carl Riccadonna, a senior economist at Deutsche Bank Securities Inc. in New York. “Most likely they will continue to reinvest over the course of the summer until they get a better sense of where the economy is,” rather than stopping immediately after the bond-purchase program ends in June, he said.

The Fed began the reinvestment policy in August, aiming to avoid what Chairman Ben S. Bernanke said was a “passive tightening” as growth slowed following the March 2010 end of the $1.7 trillion first round of asset purchases, also known as quantitative easing.

Republican Backlash

Three months later, with job growth stagnant and deflation risks mounting, Bernanke and his colleagues decided to buy $600 billion in Treasuries, a move that John Boehner, now the House speaker, and other top Republican lawmakers criticized as risking dangerous inflation. Some Republicans also advocated legislation to eliminate the central bank’s goal of maximum employment to focus on keeping prices stable.

There are differences from a year ago, when the Fed launched its second round of large-scale asset purchases, because inflation and expectations that prices will rise are higher.

Prices climbed 2.2 percent in April from a year earlier based on the Commerce Department’s personal consumption expenditures index, the fastest rate in a year. Crude oil, while down from its 2011 high of $114.83, has traded near $100 a barrel for the past two weeks.

Inflation Expectations

The difference between yields on 10-year notes and Treasury Inflation Protected Securities, a gauge of trader expectations for consumer prices over the life of the debt known as the break-even rate, fell to 2.20 percentage points yesterday, the narrowest closing spread since December. That’s still higher than 1.47 points last August, when Bernanke signaled the Fed may start QE2.

“It is likely a higher bar for QE3 than last year because the trend in inflation has been upward,” said Dean Maki, chief U.S. economist at Barclays Capital Inc. and a former Fed economist. At the same time, “the choppiness of the recovery is one reason we think the Fed will not be doing anything in terms of tightening this year.”

Any economic boost from the purchases may be starting to wear off. The economy grew at a 3.1 percent annual pace in the fourth quarter of last year; that slipped to 1.8 percent in the three months through March. The Commerce Department’s revised estimate on May 26 was lower than the median economist forecast of 2.2 percent.

Housing Slump

Housing prices, which fell in March to the lowest level since 2003, and 9 percent unemployment have reduced consumer confidence and weighed on the two-year-old expansion.

A halting recovery may harm President Barack Obama’s prospects for re-election next year, said Bill Carrick, a Democratic political strategist, particularly since jobless rates are likely to be high by historic standards.

“The danger is that if we continue to take two steps forward, two steps back, people are going to continue to suffer a high level of economic anxiety,” Carrick said. “There’s no way that can be good politically for the president.”

Feroli yesterday lowered his forecast for second-quarter growth to 2 percent from 2.5 percent, citing weakness in auto sales and construction. In a research note, he said such a level of growth would be “abysmal” considering that 14 million workers remain jobless.

Slower Growth

The Tempe, Arizona-based Institute for Supply Management yesterday said its factory index fell to 53.5 last month, the lowest level since September 2009, from 60.4 in April. Companies added 38,000 workers to payrolls, the fewest since September, according to ADP Employer Services.

The ADP report prompted some economists to cut their forecasts for job figures that will be reported tomorrow by the Labor Department. Goldman Sachs Group Inc. lowered its estimate for May’s growth in nonfarm payrolls to 100,000 from 150,000, while Deutsche Bank cut its estimate to 160,000 from 225,000.

“The Fed is very solidly on hold in that they will not do anything for the next six to eight months,” said Ethan Harris, head of developed-markets economic research at Bank of America Merrill Lynch in New York. “The Fed’s clock only moves if the unemployment rate drops, and right now, we look like we hit the snooze button on the data.”

--With assistance from Carlos Torres and Mike Dorning in Washington. Editors: Christopher Wellisz, Brendan Murray

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net; Steve Matthews in Atlanta at smatthews@bloomberg.net.

To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net


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