Bernanke's Twist Sharpens Year-End Stimulus Anxiety

(Bloomberg News) Federal Reserve Chairman Ben S. Bernanke has repeatedly warned lawmakers that a fiscal cliff threatens the economy. Now he's created a precipice of his own.

The Fed on June 20 extended its Operation Twist program to swap $267 billion in short-term securities with longer-term debt through December. That end date coincides with reductions in federal spending, a halt to payroll-tax cuts and expiration of income-tax cuts enacted under President George W. Bush.

The timing of Bernanke's easing raises the stakes for the Fed's four remaining policy meetings this year as investors focus on whether the central bank will provide stimulus for 2013 to help the economy overcome the impact of the fiscal tightening due to take hold in January, said Vincent Reinhart, chief U.S. economist at Morgan Stanley.

"They create their own monetary cliff to match the fiscal cliff," said Reinhart, former head of the Fed board's Division of Monetary Affairs. That may mean "a world of hurt" for the central bank because there would be a perception the Fed allows fiscal politics to influence its actions.

The Fed's extension of Operation Twist, along with cuts to its growth and employment forecasts, sent U.S. shares lower. Stocks rallied today, pushing the Standard & Poor's 500 Index up 0.4 percent to 1,330.96 at 9:35 a.m. in New York.

The Federal Open Market Committee should have prolonged Twist into 2013, said Kathy Jones, fixed income strategist in New York for Charles Schwab Corp., which has $1.76 trillion in client assets. "I'm surprised they didn't extend further into the first quarter to get over the hump" from fiscal tightening.

Federal Reserve Bank of St. Louis President James Bullard said in a Bloomberg Television interview today that this week's FOMC decision was a "continuation of the existing policy" as officials "felt that it was maybe a bit imprudent to end the Twist program right at this particular juncture."

"The committee has kind of been haunted by having end dates on programs," Bullard said.

Policy makers this week cut their expectations for growth in 2012 to a range of 1.9 percent to 2.4 percent, down from an April prediction of 2.4 percent to 2.9 percent. The forecasts have been lowered in five of the six economic projections since January 2011, when most central bankers predicted the economy would grow 3.5 percent to 4.4 percent in 2012.

The latest estimate is in line with those of private forecasters, who project 2012 growth of 2.2 percent, according to a Bloomberg survey. The FOMC has cut its projections for 2013 six times since January 2011.

"The Fed has repeatedly underestimated how fragile the economy is," said Ethan Harris, co-head of global economics research at Bank of America Corp. in New York. Policy makers are "being a little too optimistic that all they need to do is nudge the economy back on course and then they can stop."

Bernanke said June 20 he sees "a lot of uncertainty" about the economic outlook because of slowing global growth and financial volatility stemming from Europe's credit crisis.

Figures from the Munich-based Ifo institute today showed German business confidence dropped in June to the lowest level in more than two years. In Italy, a measure of consumer sentiment fell to the weakest level since 1996.

The fiscal cliff in the U.S. would result in a "very substantial withdrawal of income from the economy" that would damage the expansion, Bernanke said at a press conference this week after the FOMC decision. The Fed is "prepared to take additional steps if appropriate," he said.

The tax increases and spending cuts would trim a combined 3 percentage points from growth next year, according to economists surveyed last month by Bloomberg News. Political compromises would limit the damage to 0.8 percentage point, sustaining the expansion, the survey showed.

Harris predicts the Fed will announce a third round of asset purchases in September, partly to minimize damage to the economy from fiscal cutbacks. He has maintained his forecast for 1.9 percent growth in 2012 since last year and projects a 1.4 percent expansion in 2013.

"Right now, there's a guessing game about when the Fed intervenes," he said. Announcing an open-ended program conditional on the economy's health "would reduce the uncertainty around what the Fed's objectives are."

Bernanke in a 2004 speech described how monetary policy typically changes in a gradual way. In times when the economic outlook is unclear, central bankers tend to change the benchmark interest rate in small steps over time while gathering fresh information.

"Because policy makers cannot be sure about the underlying structure of the economy or the effects that their actions will have on economic outcomes, and because new information about the economic situation arrives continually, the case for policy makers to move slowly and cautiously when changing rates seems intuitive," Bernanke said in 2004.

When the Fed hit zero on the benchmark lending rate in December 2008, the option of lowering interest rates vanished, leaving policy makers with choices focused on the central bank's balance sheet. The Fed purchased $2.3 trillion of securities in two rounds of outright bond purchases and last September began extending the maturity of its portfolio.

Those programs were more of what Bernanke described in 2004 as a "big bang" approach. They also proceeded for defined periods with little regard for changes in the economy because adjustments may cause market disruptions.

The FOMC should tie its easing to the economy's outlook rather than provide finite stimulus linked to a specific date, Reinhart said.

The central bank could purchase small batches of bonds over short time periods and make them conditional on achieving a particular economic goal, said Michael Gapen, a senior economist at Barclays Capital in New York.

"The pace of purchases go up when economic conditions slow, and they slow when economic conditions improve," said Gapen, a former member of the Fed's Monetary Affairs division. That strategy averts end-point moments "when the Fed feels like it has to do something" if economic growth is weak.

Bernanke has said the Fed doesn't view the end of bond- buying programs as tightening because the measures work by removing a stock of debt from the markets rather than through the flow of purchases.

Bullard suggested tying Fed purchases to "risks that the economy faces" in a talk just before the central bank's launch of a $600 billion bond purchase program known as QE2 in November 2010.

"'Shock and awe' is almost never a good way to proceed," Bullard said in August 2010.

The FOMC hasn't adopted Bullard's idea in part because its congressional mandate is vague about how fast the Fed has to return to its goals of full employment and stable prices, and the committee is divided about how to measure near-term progress, Reinhart said.

Those divisions are visible in the forecasts the Fed published this week, which are supposed to take into account each Fed official's view of appropriate monetary policy. Policy makers said that by 2014, the unemployment rate could be 6.3 percent to 7.7 percent and put the longer-run goal for joblessness at 4.9 to 6.3 percent.

Reinhart said a communications subcommittee headed by Fed Vice Chairman Janet Yellen is probably trying to build consensus on a rule to provide a benchmark for conducting near-term policy with long-range goals in mind. Such an approach would insulate the Fed from partisan conflict over the deficit.

Purchasing more bonds to support the economy "looks like you are facilitating one side of the debate -- those who don't want fiscal consolidation," Reinhart said. "A conditional rule puts the economy between the Fed and that action. They don't have to talk about Washington at all."