May 16th, 2011

Mission accomplished?

That’s the tacit message the Federal Reserve and its chairman, Ben Bernanke, have been sending, now that the economy is recovering and companies are starting to hire again. As every Fed-watcher knows, the Fed plans to end its second bond-buying, or “quantitative easing,” program at the end of June, which presumably means it will revert to more conventional forms of monetary policy. “The Federal Reserve has taken extraordinary measures under extreme circumstances,” Bernanke said at his recent press conference. The Fed’s intention now, he said, is “to tighten policy at the appropriate time,” which normally would mean raising interest rates.

That sounds like a return to business as usual—but don’t be so sure about that. At the moment, all eyes are on the way markets react once the Fed stops buying huge quantities of bonds, a tactic many analysts believe is responsible for the rally in stocks that began in 2009, after the Fed announced and then expanded its first round of quantitative easing, QE1. Bernanke feels the Fed has signaled its pullback so far in advance that by the end of June, investors will have had plenty of time to adjust, preempting any sudden market moves. If he’s right, then the end of QE2, which began last November, will be a welcome step toward healthier and more independent financial markets.

But there could be a surprise or two. The conventional view is that the Fed will gradually shift from a loose monetary policy to a tighter one, and probably begin raising short-term interest rates sometime next year, to reduce the odds that all the money it has pumped into the economy will trigger inflation. Sooner or later, that has to happen, since short-term rates have effectively been at zero since the end of 2008. But some analysts think the Fed might have something else up its sleeve. Here are three issues that may be a bigger factor in the Fed’s thinking than Bernanke and his Fed cronies have acknowledged:

How to offset government spending cuts. Although it wasn’t popular, most economists agree that the recurring shots of government stimulus spending that began in 2008 boosted the economy and helped prevent the recession from being worse. That includes the tax cuts and unemployment insurance extensions President Obama signed into law at the end of 2010. All that spending is beginning to wind down, and it’s not clear yet if private spending will pick up enough to compensate. Plus, there’s mounting pressure to cut government spending even more, as part of a deal to reduce the deficit. “We’ve already got fiscal austerity,” economist Nouriel Roubini said at a recent conference sponsored by the nonprofit Milken Institute. “Next year there’s going to be another reduction in discretionary spending. The Fed is going to have an easier monetary policy than it would otherwise.”

There are two main issues: When the Fed will begin to raise short-term interest rates, and whether it will launch QE3, a third bond-buying program that would be an extension of its efforts to also keep medium- and long-term rates low. By saying it will end QE2 on schedule, the Fed has implied that there will be no QE3. But Bernanke has also suggested the Fed could change its mind if economic conditions deteriorate. One thing that could make that happen is deep cuts in government spending. So deficit-cutting actions by Congress could be the very thing that triggers QE3 or other aggressive action by the Fed.

Electoral politics is another wild card, which means the next 15 months or so, leading up to the 2012 elections, could be unpredictable. “The Fed needs to keep QE3 in its pocket because sometime in the next year we’re going to go from fiscal easing to fiscal tightening, at the same time we no longer have monetary easing,” said Ron Temple, a managing director at investing firm Lazard Asset Management, at the Milken conference. A modest round of QE3, he says, would amount to a “monetary palliative” that might be needed to nurse the economy for a little while longer.

How to keep interest rates low. The Fed is trying to keep interest rates as low as possible for as long as possible, hoping that cheap money will eventually spur home buyers to actually buy and companies to spend more, which in theory ought to push unemployment down. An end to quantitative easing suggests that interest rates will rise, because with the Fed out of the market for bonds, demand will fall, requiring issuers to pay higher rates to attract investors. To keep that from happening abruptly, the Fed has said it will continue to hold the nearly $2 trillion worth of bonds it has already purchased, instead of dumping them into the market and creating an oversupply of bonds.

There are a lot of reasons to expect interest rates to go up, such as inflation (if it ever arrives in earnest) or worries about U.S. debt that would force Washington to pay higher rates to borrow. But financial analyst Meredith Whitney thinks the Fed may find ways to keep interest rates low much longer than investors expect. She suggested recently that once the Fed stops purchasing bonds at the end of June, it may persuade commercial banks—which have more than $1 trillion in reserves held by the Fed—to become a substitute bond buyer, to keep demand for bonds high, and rates low. “I think rates will stay low longer than anyone imagines,” she said. “You have an idea how long rates will stay low? Double it.”

How to preempt a debt crisis. Reducing the deficit and cutting the huge national debt aren’t the Fed’s job, technically. But if there is a debt crisis, it will become the Fed’s problem because it will make inflation and unemployment—the Fed’s official concerns—much worse. So in addition to getting the economy back on track, the Fed wants to do its part now to keep a debt crisis from happening.

There’s a global wink-and-nod game going on with regard to the value of the U.S. dollar. Treasury Secretary Tim Geithner and other U.S. officials—including Bernanke—insist that they favor a “strong dollar” policy, which is always considered to be in America’s general interest. Saying otherwise would trigger a big selloff in the dollar. But the fact is that a weak dollar helps boost U.S. exports—one of Obama’s stated economic priorities—which in turn helps create jobs and reshape a trade deficit that has gotten way out of whack over the last decade. “Obviously there is not a strong dollar policy,” said Jim McCaughan, CEO of Principal Global Investors, at the Milken conference. “Their actions do not match it. They have a moderately weak dollar policy.”

Quantitative easing keeps the dollar weak by pushing down interest rates, which makes U.S. exports cheaper overseas. But that also reduces the purchasing power of U.S. consumers and leads investors to look for securities in other denominations that have better yields. If too many investors flee the dollar, the U.S. government will have to pay higher rates to borrow, which could be enough of a strain to trigger the spiraling debt crisis economists increasingly worry about. A weak dollar can also lead to inflation in other countries, which could then be imported back to the United States via higher prices for Chinese-made products, for example.

So while a weak dollar may help cure one problem, it could ignite another, which leaves the Fed pushing a weak-dollar policy it won’t acknowledge until the official strong-dollar policy looks like a better bet. And timing that turnaround is far more art than science. That kind of tightrope act is what passes for business-as-usual at the Fed these days. Which means a smooth transition to tighter money could be the biggest surprise of all.