Disentangling Two Key Concepts About Fed Policy Ahead

In the context of the debate as to when the Fed may start reversing the extraordinarily accommodating monetary policy of the last two years, a critical distinction is often overlooked: a gradual unwinding of the array of special liquidity programs and actually raising short-term rates are two very different things.

Those two types of actions are not, in fact, likely to be closely correlated, although the former action should legitimately be viewed as a precursor of the latter. Still, the time gap between those two phases can be quite significant.

The Fed is under tacit pressure from the ever inflation-sensitive bond market to demonstrate vigilance with regard to the gradual withdrawal of the massive liquidity injected into the system in the last two years or so. The Fed is very mindful of such market expectations, as well as of the undeniably real risks that all of these liquidity injections imply if not offset at the appropriate time, and is likely to start moving in that direction once evidence that the economic recovery is embarking on a solid track emerges. In fact, this week's reports about the Fed consulting with primary dealers about the logistical aspects of reverse-RPs and the slower pace of purchases of mortgage-backed and agency securities announced by the FOMC on Wednesday should be viewed as signs that such a process is already underway in a low-key manner. Other such steps should be expected to follow as part of a carefully calibrated process through the turn of the year, increasing the number of special programs that the Fed is already dialing down without much fanfare in the last few months.

Still, initiating steps that are meant to address the scope of the various liquidity programs is not tantamount to approaching the point of an actual tightening of monetary policy in a more conventional sense (i.e, raising rates); the standard that needs to be met for the latter to occur is a much higher one.

It is extremely difficult (or, should we say, inconceivable?) for the Fed to start raising the funds rate in an environment where bank lending remains tight- therefore, sustaining a degree of anxiety about the amount of traction the recovery will ultimately gain- and the unemployment rate is on the rise. The upward trajectory of the unemployment rate could persist well in to 2010, representing a major impediment to any prospect of a rate hike, at least through next summer.

In other words, one should take on face value the FOMC's diligently repeated assertion in its recent statements that the federal funds rate is likely to remain at exceptionally low levels for an "extended period". Even after the front end's rally in response to the FOMC statement on Wednesday, fed funds futures are still pricing nearly a full 25 basis point tightening move by next April, which, while not outlandish, should be viewed as a low probability outcome.

AK