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Is the Fed hinting at its exit strategy?

March 20, 2013

| MoneyRates.com Senior Financial Analyst, CFA

The announcement from this week's Federal Open Market Committee (FOMC) meeting acknowledged some recent improvement in the economy, but spelled out no specific exit strategy for the Fed's current stimulative policies. Reading between the lines though, there may be hints on how that exit will play out.

Highlights of the FOMC statement

Here are some highlights from the March 20 FOMC statement:

  • Several private-sector indicators have shown improvement since the January Fed meeting.
  • The Fed makes no specific reference to the ongoing budget crisis in Washington, beyond noting that "fiscal policy has become somewhat more restrictive."
  • As usual, the statement reiterates that the Fed is trying to strike a balance between maximizing employment and keeping inflation under control.
  • In the context of balancing the above goals, the Fed notes that it is tilting its policies toward stimulating employment, since unemployment remains a problem while inflation has remained moderate.
  • The Fed is continuing its stimulative policies of keeping short-term interest rates between 0 and 0.25 percent, and buying mortgage-backed securities and long-term bonds.
  • The Fed is looking for signs of sustainable growth before it will consider changing these polices.

The somewhat inscrutable nature of the language used in FOMC statements often leaves them open to interpretation, and lately the hottest topic of speculation about the Fed has been when it will end its current stimulative policies.

Hints of an exit scenario

The Fed has long had two stimulative initiatives in place -- keeping short-term interest rates near zero, and steadily buying bonds to drive longer-term rates down. The question of how it will ultimately walk back from these policies is an important one, because doing so too soon or too suddenly could put the brakes on the economic recovery.

So far the most concrete thing the Fed has said is that as long as inflation remains under control, it is looking for unemployment to get down below 6.5 percent before it will consider raising short-term rates. However, it has hedged the timing by saying short rates will likely remain low "at least as long as" unemployment remains above 6.5 percent. As for the bond purchases, the Fed has stated that these will probably cease before short-term rates are raised, but it doesn't say how long before.

While keeping the timing fuzzy, the Fed seems to be pointing out the type of circumstances that would lead it to discontinue its stimulative policies. It seems to want to let the news sink in slowly as those circumstances develop, so as not to create any sudden shock to the markets. Among other things, this would allow bond yields to rise gradually as economic conditions improve, rather than having an unexpected change in direction by the Fed causing a panic in the bond market.

In short, while the Fed hasn't specifically spelled out an exit strategy, the way it is describing the eventual end of its stimulative initiatives may be the very beginning of that exit strategy.

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