Federal Reserve hopes clear exit strategy will boost market confidence

When you’ve flooded the economy with trillions of dollars, mopping up is no easy task.

That’s the reality the Federal Reserve is confronting as it starts to explain how it will undo the aggressive growth-supporting steps that were put in place when the economy was in its deep dive — and begins to be clearer about when that may happen.

But it is a fraught exercise. Federal Reserve leaders and private economists expect the jobless rate to remain high for years, despite a dip in the unemployment rate to 9.7 percent in January, and the Fed could make the situation worse if it moves too abruptly. In the meantime, financial markets have shown new signs of fragility, swooning in the past three weeks, including a 1 percent drop in the stock market Monday that drove the Dow Jones industrial average to close under 10,000 for the first time in three months.

Fed Chairman Ben S. Bernanke is betting that if the central bank is open about how it will phase out its expansive initiatives to prop up the economy, it will provide faith that the Fed will not allow inflation to flare down the road. That in turn would help keep long-term interest rates low and could allow the Fed to keep the short-term rates it controls at ultra-low levels for longer.

“You’re trying to inspire confidence that you know what you’re doing, which can help put the brakes on any incipient inflation without damaging the recovery,” said Karen Dynan, a Fed economist until last year who now co-directs the Brookings Institution’s economic studies program.

But that strategy comes with risks. Most notably, investors may interpret the talk about reducing the money supply as a sign that those steps are imminent. That could prompt interest rates to rise sooner than the Fed would like, which could slow the economic recovery or even stop it.

Bernanke is scheduled to testify before the House Financial Services Committee on Wednesday about unwinding Fed actions and will probably elaborate on those plans later in the month with his semiannual testimony on Capitol Hill about monetary policy.

Once the time comes, the Fed is likely to sop up cash from the economy by increasing the interest paid on excess bank reserves. Banks often park money they aren’t otherwise using — for instance, lending to borrowers — at the Fed and are currently paid 0.25 percent interest on those reserves. If inflation became a threat, the Fed could raise the interest rate, giving banks an incentive to park even more cash rather than lending it.

The Fed has been able to pay interest on reserves only since the power was included as a little-noticed part of the law that created the $700 billion federal bailout, known as the Troubled Assets Relief Program, in October 2008. But now, Fed officials view this authority as a key element in the central bank’s tool kit for managing the economy. This power could even eclipse the approach the Fed has traditionally used to influence the economy: setting a target for the “federal funds rate” at which banks lend to one another.

“Interest on reserves is the workhorse . . . and is intended to be the main tool” in the Fed’s exit strategy, James Bullard, president of the Federal Reserve Bank of St. Louis, said in an interview Monday. That, he added, has created significant discussion within the Fed about how to make policy in the months and years ahead.

“The old regime was it was always about the fed funds rate,” Bullard said. He added: “You had a long history of what the impact on the economy was of a change in the rate. We don’t have that now, and it doesn’t look like we’ll really be back in that scenario anytime very soon.”

The Federal Reserve Bank of New York, which executes the central bank’s monetary policy by buying and selling securities, has been experimenting with other tools that might allow it to drain the money supply, including “term deposits.” These would essentially give banks incentive to deposit money at the Fed for a set period of time. The Fed is also testing reverse repurchase agreements, which would allow the central bank to temporarily swap assets on its balance sheets for cash, thus pulling that cash out of the financial system.

As of Feb. 1, the Fed ended several of its more unconventional lending programs that were started during the depths of the financial crisis. And Fed leaders have said it will cease purchases of $1.25 trillion in mortgage-backed securities by the end of March. A knottier question is when it might sell some of those securities on the open market, as opposed to letting them reach maturity over many years.

Selling these securities would pull money out of the economy and shrink the Fed’s $2.2 trillion balance sheet, helping to avoid inflation and getting the Fed out of the business of subsidizing mortgages. But selling the assets probably would drive up mortgage rates, damaging a housing sector whose recovery is slow and fragile.

So far, the Fed has convinced markets that the “how” of unwinding support for the economy is separate from the “when.” As for when the rate increases will begin, that will depend on how the economy is doing and whether inflation expectations rise. If the recovery fizzles, the central bank would wait longer. If there is a strong burst of growth, rates would increase sooner. Similarly, the Fed would probably raise rates sooner and more aggressively if investors began to expect a burst of inflation.

At its policymaking meeting in late January, the Fed said it is likely to keep interest rates “exceptionally low” for “an extended period,” repeating language it has used for more than a year. While Fed policymakers have differing views on how long an extended period would be, William C. Dudley, president of the Federal Reserve Bank of New York, said last week that it means rates will stay very low for at least six more months.

The financial markets will be closely watching Bernanke testify Wednesday before the House Financial Services Committee. After all, the key to Bernanke’s strategy is winning is the confidence of market participants in the Fed ability to drain cash from the system.

“I think the markets would like to have a bit more transparency on the exit strategy plans,” said Kurt Karl, chief U.S. economist at Swiss Re. “It’s probably the right time to provide more detail. As I understand it, the chairman will provide quite a bit of detail, though perhaps not as much as the market wants.”