June 29, 2009 / 12:03 PM / 10 years ago

RPT-FED FOCUS-Fed's baby exit steps show rate hike far off

(The story is a repeat which initially was carried on Friday)

By Kristina Cooke

NEW YORK, June 29 (Reuters) - The U.S. Federal Reserve’s baby steps last week toward scaling back some of its emergency market lifelines underscore just how far off an interest rate hike actually is.

The U.S. central bank on Thursday dropped a liquidity program for money markets and trimmed the size of a handful of other facilities. But it largely kept its liquidity safety-blanket in place, extending the life of most programs on the expectation that financial strains will remain for some time.

These emergency programs were put in place after fear of huge losses in the financial crisis froze key credit markets and are only authorized under a section of the Federal Reserve Act if conditions are “unusual and exigent.” By extending them until February of next year, the Fed suggested it expects markets to remain vulnerable until then.

“It is extremely difficult to argue that the presence of such circumstances could be consistent with a decision to hike the federal funds rate,” Goldman Sachs economists said in a research note. No economists in a Reuters poll of primary dealers taken after a Fed policy meeting on Wednesday saw the U.S. central bank hiking interest rates before 2010. [FED/R]

Analysts and investors have been questioning how the Fed, which has pumped more than $1 trillion into strained credit markets since the crisis struck, will reverse course once a recovery gains steam.

Any “exit strategy” would require a delicate balance: removing extra liquidity too soon could squash a recovery, but moving too slowly could spawn inflation. It is a topic that looks set to grow in contention among policymakers as the economy heals.

TOO SOON TO TIGHTEN

If the Fed had decided not to extend the bulk of these emergency facilities past their previously scheduled expiry in October, it likely would have been perceived as a first step toward tightening monetary policy — something the Fed has stressed it is not yet ready to do. This way, they only trimmed those facilities that were seeing “very weak demand.”

The Fed on Thursday extended both its commercial paper funding facilities, which help ensure access of U.S. companies to short-term funding, and its credit facility for institutions that do business directly with the central bank.

It also extended its Term Securities Lending Facility (TSLF), in which the Fed lends securities to primary dealers for a term of up to 28 days, though it cut the program’s frequency and ended one of the auction types.

The Fed said it would not extend a program for money markets beyond October and cut the amount of liquidity offered via the Term Auction Facility (TAF). For more details on the programs, please see [ID:nN25296752]

The actions “do not practically reduce the liquidity available to the market, (but) they do highlight that the need to reduce the size of the Fed’s balance sheet is a key concern for the Federal Reserve,” said Drew Matus, an economist at Bank of America Merrill Lynch.

The fact the Fed has given seven months notice of when it might pull the plug on these programs — and added that it would give advance warning if the date changes — suggests it is unlikely to spring a policy shift on unsuspecting markets.

Matus said the program extensions make rate hikes prior to a planned March 16, 2010, policy meeting “that much more unlikely.”

Demand for the emergency liquidity programs has fallen sharply as market conditions have improved, even among those facilities the Fed is keeping in place as insurance. After peaking at more than $1.5 trillion late last year, use of the facilities has declined to around $670 billion, a Fed report on Thursday showed.

“They are inching toward the exit but making no abrupt move that could disrupt markets and force the Fed to back-pedal,” said Michael Feroli, an economist at JPMorgan.

But even with the drop-off in demand, the Fed’s balance sheet has only shrunk slightly. It is still above $2 trillion — more than double the pre-crisis size — and excess bank reserves remain high.

That’s because even as liquidity facilities contract, the Fed is making its way through large-scale asset purchases — the centerpiece of its so-called “credit easing” policy that targets specific markets to lower borrowing costs.

Unlike the Bank of Japan in the 1990s, which focused on the liabilities side of its balance sheet as it pumped more and more reserves into the banking system, the Fed is focusing on the asset side, which means the size of its balance sheet is a less important determinant of the stance of policy.

The longer-term assets it is still accumulating, analysts say, will be more of a headache to get rid of without disrupting fragile markets.

But with 40 percent of its planned $300 billion of government debt purchases still ahead and the Fed warning of continued market strains, a shift in policy, it seems, is still a long way off. (Editing by Kenneth Barry)

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