Delamaide: Fed ends stimulus, faces new hurdles

WASHINGTON — The successful end of the Federal Reserve's monetary stimulus program is an important milestone on the road back to financial normalcy, but there are still some treacherous hurdles ahead.

Fed officials had clearly announced that its monthly purchase of bonds – a way of injecting more money into the financial system – would be ending this month after they have been reducing the amount purchased since last December.

The fact that the actual decision announced Wednesday caused scarcely a ripple in the markets is a tribute to the Fed's growing ability to manage investor expectations – a communications exercise that Fed officials call "forward guidance."

Fed chair Janet Yellen had said at a news conference after the previous monetary policy meeting in September that "if incoming information broadly supports the committee's expectation of ongoing improvement in the labor market and inflation moving back over time toward its 2% longer-run objective, the committee will end this program at our next meeting."

The concern about inflation has been not too much of it, but too little. The Fed's 2% target cuts both ways. It does not want inflation to exceed that level by too much, but it does not want it to fall short, because that can hurt the economy as well.

In any case, the headline consumer price index rate in September remained steady at 1.7% year on year, unchanged from August.

Unemployment continued to decline, falling to 5.9% in September from 6.1% in August. But Yellen and other Fed officials worry that the headline figure understates the real situation. Some people have dropped out of the labor market because of frustration at not finding a job, and others are working part time when they would prefer a full-time job.

The Fed has learned to communicate better in the school of hard knocks. When it first announced last year it was going to start "tapering" its bond purchases from the $85 billion a month they had maintained since December 2012, investors were caught unaware and there was a market sell-off that came to be known as the "taper tantrum."

The next challenge is to communicate when monetary policymakers will start to raise interest rates, a further tightening of the monetary screws after ending the bond purchases. Most Fed watchers expect the Fed won't start raising rates, expressed in the target rate for the money it lends banks overnight, until the second half of next year.

This benchmark rate has been at virtually zero since December 2008, as part of the Fed's response to the financial crisis. It is one of the ways that the Fed has tried to encourage companies to invest and create jobs and consumers to spend money and buy homes.

Economic recovery has been relatively weak and erratic, however, so most Fed policymakers are reluctant to consider an increase in interest rates until economic growth, and particularly improvement in the employment situation, shows signs of sustainable improvement.

Some of the hawks on the Federal Open Market Committee, the monetary policy-setting panel composed of the Fed's board of governors and the heads of the 12 regional banks, want to raise interest rates sooner, keeping the Fed ahead of the curve and curbing any possible surge in prices.

But the majority on the committee are wary of moving too soon and sabotaging the recovery, forcing them to backtrack and adopt more stimulus measures again.

The Fed emphasized in Wednesday's statement, as it has consistently while tapering the monthly bond purchases down to $15 billion last month, that monetary conditions are still quite "accommodative" for the economy to grow.

Through its successive programs of securities purchases — the one just ending was the third, or QE3, for "quantitative easing" — the Fed has expanded its balance sheet from less than a trillion dollars to more than $4 trillion. It will keep it at this level by reinvesting bond principal when the bonds mature, even though it is no longer adding to it with new purchases.

Fed officials do not expect conditions to return to normal until well into 2017. Even if it does start to raise interest rates next year, most FOMC members do not expect to get to the 3.75% considered normal until late in 2017.

At that point, Fed officials would like to see the economy growing robustly, unemployment to be near 5% after reabsorbing more people back into the labor market and inflation stable at 2%.

To achieve that without major market disruption, they will have to successfully pick the time to start raising rates, clearly signal to investors when that will be and by how much, decide when to start reducing their balance sheet by not reinvesting principal, and introduce new tools for managing interest rates in today's changed environment.

It's a tall order and will require the Fed to maintain a delicate balance between too little and too much monetary accommodation while managing investor expectations.

This week marked an important step forward, but monetary officials will not be resting on their laurels.

Darrell Delamaide is a columnist who has reported on business and economics from New York, Paris, Berlin and Washington for Dow Jones news service, Barron's, Institutional Investor and Bloomberg News service, among others.