Yellen triggers plan to cut stimulus and avoid disaster: Don Pittis

With deadly earthquakes, hurricanes, floods and fires, this seems like a season of disasters.

Yesterday the world’s most powerful central banker, Janet Yellen, demonstrated that she is determined not to create another disaster in financial markets in spite of a dramatic change in course.

Yellen threw the switch on a plan to reverse one of the two methods central banks have used to recharge an economy battered by the 2008 financial storm.

Yellen, the U.S. Federal Reserve chair, has now formally asserted that she will withdraw both those kinds of monetary boosts to the economy, the stimulus of low rates and the slightly more complex stimulus of buying up bonds.

Nerve-racking peak

And rather than creating a shock wave likely to tumble stock markets, now trembling near a nerve-racking peak, it appears  the cautious Yellen has once again proved her worth as a safe pair of hands.

“The decisions that we’ve made this year about rates and today about our balance sheet are ones we’ve taken because we feel the U.S. economy is performing well,” Yellen told reporters at yesterday’s news conference.

CANADA-ECONOMY/HOUSING

Canadian borrowers may not be pleased that Yellen said that she expects the U.S. Fed rate to rise from 1.25 per cent now to 2.9 per cent in 2020, but a gradual increase is better than the market chaos some have feared. (Chris Wattie/Reuters)

Many Canadians have learned from painful experience about the impact of interest rates following the Bank of Canada’s recent increase. Higher rates make money more expensive and, other things being equal, they discourage people and companies from taking on more debt.

Yellen said yesterday that despite low inflation, the U.S. expects to continue raising rates with the intention of cooling the economy. While Yellen left rates unchanged this time, she confirmed expectations of another increase this year and more to come.

But the thing she did announce yesterday, which she seems, so far at least, to have handled deftly, is the “balance sheet” part. Its effects are more nuanced.

Perhaps in a time of disasters, a flood analogy would help to explain the Fed’s plan.

In the wake of the 2008 market shock the U.S. central bank and others around the world did not just cut interest rates.

The Fed under Yellen’s predecessor Ben Bernanke began buying up mortgages and long-term bonds, using money imagined into existence by the central bank, eventually accumulating a huge reservoir of these financial instruments which they kept on the Fed’s books, or “balance sheet.”

In normal times the Fed keeps some securities on its books so that it can use them to intervene in markets to increase stability.

Bond-buying binge

But as a result of the post-2008 bond-buying binge, somewhat confusingly called “quantitative easing,” the central bank has nearly $4.5 trillion US worth of bonds and mortgage-backed securities dammed up in its reservoir. Some economists worry such a vast lake of bonds is distorting the market and is in danger of distorting it more if it gets out suddenly.

Now Yellen and her team want to at least partially drain the reservoir. But they are anxious not to create a flood.

Damaged Dam

Water gushes from the Oroville Dam’s main spillway in California on Feb. 14. Dam experts say bad design and construction a half-century ago contributed to a disastrous spillway collapse. U.S. Fed chair Janet Yellen aims to avoid a similar financial outpouring. (Marcio Jose Sanchez/Associated Press)

In 2013 Bernanke caused a brief market panic dubbed the “taper tantrum” by merely hinting he was going to gradually stop adding to the reservoir.

But this time Yellen seems to have chosen her strategy and her timing well.

Without putting the plan into effect, the Fed laid out her hydrological project carefully months in advance.

Avoiding a tailspin

The plan was to gradually release measured amounts into the spillway, so the financial lakes and rivers downstream could absorb the discharge without overflowing their banks and creating a dangerous flood that would drive interest rates up sharply and waterlog markets.

The Fed plan is not to sell bonds. Instead, when bonds in the portfolio reach their maturity date and pay back their principal, the central bank will simply not buy new ones, thus reducing the total amount on its books.  

Yesterday Yellen announced the plan is to start in October, letting $10 million worth drain out of the reservoir and into the normal economy. Then after that, the monthly discharge will gradually increase in a series of planned steps, allowing markets to learn how to absorb the outflow.

If the economy continues to be stable and inflation begins to kick in as the Fed’s advisory committee forecasts, then a slight rise in rates caused by lowering the reservoir will be just what the doctor ordered. 

As Yellen explained yesterday, if a fine-tuning of stimulus is needed, either up or down, the Fed still has the power to adjust interest rates.

“If there is some small negative shock our first tool, our most important and reliable tool, would be federal funds rate,” she said.

Effectively, Yellen says, the central bank does not want to adjust the plan and start buying bonds again except in the case of “a significant shock that’s a material deterioration to the outlook.”

That is the statement that ties her hands.

The Fed can change its reservoir-draining plan if necessary, but Yellen likely knows tinkering with the strategy now that it’s in place would signal more uncertainty and instability, with the danger of provoking a disaster she is anxious to avoid. 

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