When Ben Bernanke goes before reporters in his first live press conference next week, there’s one question I guarantee he won’t answer: “When will you start raising interest rates again?”
The Federal Reserve chairman may tell the media that the latest round of “quantitative easing” (QE2) will wind up as scheduled on June 30. He also may say that the economy is showing signs of a self-sustaining recovery.
But he won’t tell us what we really want to hear—how long it will be before the Fed hikes short-term interest rates.
However, one expert thinks he has the answer: April 2012, a year from now. That may seem like an eternity to people who worry that the inflationary wolf is already knock-knock-knocking on our front door.
But Joseph Kalish, senior macro strategist of Ned Davis Research in Venice, Florida, thinks it’s consistent with the behavior and attitudes of key players on the Federal Open Market Committee, the Fed’s rate-setting body.
Kalish has pored over minutes of Fed meetings, voting records of FOMC members, and public statements by Fed officials to construct a possible timeline of Fed tightening. It’s a mixture of “Fed watching” — which economists did when the central bank was far more opaque than it is now — and Kremlinology, the art of who’s in and who’s out at powerful institutions.
Ben Holds the Cards
Kalish says the key word to describe this Fed is “deliberate.” The bank doesn’t make big moves until the chairman and his allies are sure they want to go that way. Then, they don’t look back.
“Bernanke’s not about to change course until he’s absolutely certain,” Kalish told me. “He’s very afraid of tightening too quickly.”
He has two key supporters: Vice chairman Janet Yellen, and William Dudley, president of the powerful Federal Reserve Bank of New York and a former chief US economist for Goldman Sachs Group (NYSE:GS). They’re firmly in the chairman’s corner, according to Kalish.
Two other bank presidents, Richard Fisher of the Dallas Fed and Charles Plosser of Philadelphia, are inflation hawks. They want QE2 to end and the central bank to begin raising rates. Narayana Kocherlakota of Minneapolis generally supports their position.
The four other voting members of the FOMC tend to side with the chairman, Kalish said.
When he does the math, his conclusion is that Bernanke "can get his way.” And the chairman is likely to take the slow road back to higher rates.
Why? Despite nearly two years of recovery, output remains 7% below its September 2007 peak, just before the recession officially began. The chairman worries that deflation is a disease that’s devilishly hard to cure once it infects an economy.
So Bernanke and his allies won’t pivot to fight inflation until they’re sure the deflationary dog is dead. That, of course, could cause them to fall behind the curve in the fight against inflation, but it’s a risk Bernanke seems ready to take. He’s said he has the tools to fight inflation and will use them when he needs to. We’ll see.
So what will prompt a change in direction? “The level of the unemployment rate and its rate of change will strongly influence the timing ... of tightening policy,” writes Kalish.
As Bernanke testified before Congress last month, “Until we see a sustained period of stronger job creation, we cannot consider the recovery to be fully established.”
According to Ned Davis Research, since 1955 the Fed has made its first post-recession rate hike:
- A median 20 months after the unemployment rate peaked
- After the unemployment rate had dropped a median 1.2 percentage points
- When the official rate was no higher than 7.5%
Unemployment peaked at 10.2% in October 2009 in this recession. Twenty months from then would be June 2011, but the depth of this downturn likely has thrown off that timetable. The rate also already has dropped 1.4 percentage points from its high.
Yet at a recent 8.8%, it remains well above normal recession highs. If current trends continue, however, official unemployment may fall below 8% by next year, giving the Fed more room to tighten. Meanwhile, the Federal Funds rate has been at 0% to 0.25% since December 2008.
China's and India’s central banks already have raised short-term rates, as have those of developed economies like Australia and Canada. The inflation-phobic European Central Bank recently kicked up its short-term rates by 0.25 percentage points for the first time in two years.
Only the Fed and the Bank of England have held back. But if big gains in commodities prices push “core” inflation (currently running at 1.2%) persistently higher, Bernanke will have to act.
But He’ll Have to Clear Away Lots of Brush First
Because the Fed couldn’t lower rates any further, even though the economy was in such a deep hole, Bernanke resorted to the printing press — or more accurately, to the Fed’s balance sheet.
The central bank bought hundreds of billions of dollars of Treasury and mortgage-backed securities, raising the value of securities held to $2.6 trillion, from around $850 billion in early 2008. It will have to start unwinding those purchases before raising rates again.
Here’s Kalish’s timetable: Some time soon, maybe at next week’s meeting, the Fed will announce it is ending QE2 after completing its purchase of $600 billion in additional securities. Then it will hold its portfolio constant for a while by reinvesting the proceeds from maturing securities, and then stop reinvesting interest and capital gains to allow “organic” shrinkage of its balance sheet. Each of those steps, he estimates, will take three to six months.
By next March, Kalish thinks, the Fed will remove the key statement that conditions “are likely to warrant exceptionally low levels of the Federal Funds rate for an extended period.” That will be a clear signal that short-term interest rates will head higher soon.
He pegs the official rise at next April, and thinks that in the months after that, the Fed will slowly boost the funds rate until it gets to a more “normal” level — I’d say 3% or so. That would still be pretty low historically, and it would give the Fed plenty of room to hike more if inflation takes off.
Kalish’s scenario is hypothetical, but I think it’s reasonable. Will it happen? Who knows? Just don’t expect to find out next week when Ben Bernanke meets the press.