Strengthening U.S. Recovery May Intensify Fed Debate on Exit

By Craig Torres
Jan. 15 (Bloomberg) -- Federal Reserve officials are more confident the U.S. economy is moving toward self-sustaining growth, giving urgency to discussions about the tactics and timing of an exit from record-low interest rates.
Kansas City Fed Bank President Thomas Hoenig said Jan. 11 the central bank should end purchases of mortgage-backed securities because the market is "healing." Philadelphia Fed Bank President Charles Plosser said the next day that the recovery is "sustainable even as the fiscal and monetary stimulus programs eventually wind down."
Policy makers are still studying ways to drain $1 trillion in excess cash from the financial system and debating how to signal a rate increase that economists say is at least 10 months away. The first test of their exit strategy will come in March, when the Fed’s purchases of $1.25 trillion of mortgage-backed securities are scheduled to end.
"They’ll tell themselves the unusual support is no longer necessary, the recovery is self-sustaining," said Vincent Reinhart, a resident scholar at the American Enterprise Institute in Washington who served as director of the Fed’s Division of Monetary Affairs under Chairman Ben S. Bernanke.
"Deep down, they probably also believe they have the option of starting up again."
A government report yesterday showed business inventories rose more than forecast in November as companies tried to keep up with a jump in sales. Fed officials are watching to see if inventory restocking sparks gains in jobs and incomes that will boost spending, leading to further increases in hiring.

Rate Forecast

The Fed will keep its target for overnight lending among banks unchanged through September and raise it by half a point in the fourth quarter, according to the median forecast in a Bloomberg News survey of economists. Policy makers, who have kept the benchmark rate near zero since December 2008, next meet Jan. 26-27.
The world’s largest economy will expand 2.7 percent this year, the best performance in four years, the Bloomberg survey showed. Consumer purchases will grow 2 percent, up from a December estimate of 1.8 percent and the first gain since 2007, according to the median forecast of 60 economists.
Macroeconomic Advisors LLC, a St. Louis-based forecasting firm, says the economy probably expanded at a 5.5 percent annual pace in the fourth quarter, the fastest in more than five years.
Demand will be partly driven by business investment and exports, their forecast shows. Consumption should be supported by household wealth as stocks climb and housing prices steady.
The Standard and Poor’s 500 Index is up 36 percent over the past year.

Consumer Spending

"The drag on consumer spending from rapid declines in wealth has gone away," said Ben Herzon, an economist at Macroeconomic Advisers. "Demand will pick up."
The Fed’s Beige Book business survey released Jan. 13 signaled the recovery is broadening, with 10 of the Fed’s 12 district banks reporting an improvement last month. Home sales increased toward the end of last year in most Fed districts, the report showed, and manufacturing improved or held steady while the labor market and loan demand remained weak.
Fed purchases of mortgage-backed securities have helped stabilize the housing market, which was at the epicenter of the financial crisis, by pushing down borrowing costs for home buyers. Government tax credits also helped propel existing home sales to the highest level in almost three years in November.
Yields on Fannie Mae and Freddie Mac mortgage securities are near the lowest relative to Treasuries in nearly two decades.

Interest-Rate Spread

The difference between yields on Washington-based Fannie Mae’s current-coupon 30-year fixed-rate mortgage bonds and 10- year Treasuries stood at 0.69 percentage point Jan. 14, up from
0.65 percentage point on Jan. 6, which was the lowest since May 1992, according to data compiled by Bloomberg.
Central bankers, like private economists, expect some increase in mortgage rates as purchases of securities tail off.
"As our agency mortgage-backed securities purchases come to an end, we’ll probably see a little bit of upward pressure on interest rates," New York Fed President William Dudley said on Jan. 13 in an interview with PBS Television’s Nightly Business Report. "But there’s a big debate about whether they’ll be small or medium or large. So I think we’ll have to wait and see."
Economists expect the rate on a 30-year fixed mortgage to rise 30 basis points after the Fed’s purchases end, according to the median of 39 economists surveyed by Bloomberg News between Jan. 5 and Jan. 12. The average rate on Jan. 14 was 5.06 percent, according to Freddie Mac.

Convincing Signs

Central bankers are likely to keep rates unchanged until they see convincing signs the rebound in manufacturing generates enough jobs and income to spur household demand and reduce unemployment that’s near a 26-year high.
The U.S. unexpectedly lost 85,000 jobs in December, and revisions showed payrolls increased in November for the first time in almost two years, a Labor Department report showed this month. The jobless rate stayed at 10 percent in December.
Job growth "will not likely be rapid enough to put a large dent in the unemployment rate," Fed Bank of Boston President Eric Rosengren said in a speech on Jan. 8. "This should allow for accommodative monetary policy to continue to support the economy until the underlying demand of consumers and businesses becomes self-sustaining."
Rosengren like Hoenig is a voting member of the Federal Open Market Committee this year.
Sales at U.S. retailers unexpectedly fell 0.3 percent in December, a Commerce Department report showed yesterday. After- tax personal income adjusted for inflation was up 1.5 percent in the year ended in November, compared with an average 3.3 percent gain in the decade before the recession.
"Short-term rates are going to stay low for a considerable period of time," the New York Fed’s Dudley said Jan. 13. The policy of keeping borrowing costs low could remain in place "at least six months," Dudley said. "It could be a year from now, two years from now. It’s going to depend on how the economy develops."