SAN FRANCISCO (Reuters) - With the jobs market showing signs of healing, economists think they know what’s next for monetary policy: the Federal Reserve will at some point taper its monthly bond purchases, and soon after, end them altogether.
But perhaps they shouldn’t be so sure.
The Fed is currently buying $85 billion in mortgage-backed securities and Treasuries to inject more money into the economy to help boost growth and hiring. Friday’s report of better-than expected jobs growth in February boosted speculation that the Fed may trim those purchases sooner than previously thought.
The view that such a move is necessarily a prelude to the program’s end sets markets up for an economically damaging spike in interest rates, and quite possibly a slump in stock prices, at the first hint that the Fed is ready to dial back its third round of bond buying, or quantitative easing.
And that’s an outcome Fed Chairman Ben Bernanke and other top central bank officials will want to avoid.
“When they do begin to exit ... they very well could indicate that the quantitative easing could get bigger or smaller, as a way to reinforce their flexibility and keep rates markets from selling off too much,” said Eaton Vance portfolio manager Eric Stein, a former analyst at the New York Fed.
The Fed is not expected to change the bond-buying program when its policy-setting panel meets next week, and most top Wall Street economists expect the Fed to continue to buy bonds through 2013 and into 2014.
But seven of 11 top Wall Street economists polled by Reuters on Friday also believe that if the Fed does reduce the pace of its bond-buying at some point, the move would signal that it is aiming to shutter its program within a few months.
To counter that expectation and soften the market impact, Fed officials will want to make clear that they could ramp the program back up again if the jobs market weakens, said Wells Fargo economist John Silvia.
The message “may surprise the market, but it will be very reassuring that they are not in a game where it’s black and white,” Silvia said.
From the very start of their open-ended bond-buying program last September, U.S. central bank officials said they wanted to be able to slow or speed the pace of their purchases depending on signals of the economy’s health.
But doing so poses difficult challenges.
Schooled by years of careful Fed watching, investors pretty much know what to expect when the central bank begins raising or lowering rates.
But the Fed has been holding short-term rates near zero since December 2008, and has pledged to keep them there for a “considerable time” even after the economy strengthens.
Investors meanwhile have little experience with what to expect if the Fed adjusts its pace of bond purchases and, by extension, the size of its hefty asset holdings, now worth $3 trillion.
“There is some growing sentiment for using the balance sheet a little more actively as a policy tool,” Peter Hooper, chief U.S. economist for Deutsche Bank Securities, said last week. “But I also see problems with the communication issue, and making things clear to the market.”
Problems could include choppy market reaction, as traders digest potentially conflicting messages from Fed officials with divergent views on where policy is likely to head, as well as economic data releases.
When minutes from the Fed’s January policy-setting meeting were released last month they showed that a number of Fed officials thought the cost of bond buying might force an end to it before the jobs market improves. In response, yields on 10-year Treasuries rose near the quarter’s then-high of just over 2 percent.
Then, Bernanke delivered a vigorous defense of the program, pushing down bond yields, which later rose again as economic data showed the jobs market was improving.
On Friday, a government report showed U.S. employers added 236,000 jobs to their payrolls last month, many more than analysts had expected.
Even after February’s strong jobs showing, Navigate Advisors LLC managing director Tom di Galoma still sees the Fed continuing its purchases through at least year end, “if not even further into the future.”
But if the Fed does move to scale back purchases, rates could rise dramatically, with a $15 billion monthly cut pushing the yield on the 10-year Treasury to near last year’s high of 2.38 percent, he said.
The stock market could also tank, said Jack Ablin, chief investment officer at BMO Private Bank in Chicago.
“I think if the Fed announced a reduction in its asset purchases, it could upset the stock market,” sending the Standard & Poor’s 500 Index to 1500 or below, he said. The S&P 500 Index closed on Monday at 1556.22.
If history is any guide, Federal Reserve policy shifts after long periods of policy easing can be jarring.
In February 1999, when Alan Greenspan, then Fed chairman, initiated a surprise tightening, financial assets were dealt a body blow. Over the ensuing three months, the total return for Treasury debt was a negative 6.2 percent, according to Bank of America Merrill Lynch Fixed Income Index data, and the Standard & Poor’s 500 index sank 7.25 percent on a total return basis.
Many Fed officials, including some of Bernanke’s closest allies on the policy-setting panel, see the bond-buying program continuing for some time.
Chicago Fed President Charles Evans, whose views on the ideal path for Fed policy have shaped the central bank’s stance, wants to see six months of jobs gains topping 200,000 before he would pare bond buying.
And some economists think the market is not adequately pricing in the possibility that the Fed could do more to ease policy, as Minneapolis Fed President Narayana Kocherlakota has advocated.
“Open-ended doesn’t only mean you reassess it from meeting to meeting - it would mean that you are open to an increase,” said Clark Yingst, chief market analyst at Joseph Gunnar & Co in New York. “I think the market is not open to the possibility.”
Additional reporting by Ellen Freilich, Julie Haviv, Chris Reese and Jonathan Spicer in New York; Editing by Daniel Burns, Martin Howell and Tim Dobbyn