Fed Reverses Exit Plan With $2 Trillion Holding Floor

Fed Reverses Exit Plan With $2 Trillion Holding Floor (Update1)

By Craig Torres and Vivien Lou Chen

Aug. 11 (Bloomberg) -- The Federal Reserve reversed plans to exit from aggressive monetary stimulus and decided to keep its bond holdings level to support an economic recovery it described as weaker than anticipated.

Central bankers meeting yesterday adopted a $2.05 trillion floor for their securities portfolio, pivoting toward a quantitative target for monetary policy. Treasuries surged and stocks pared losses as some investors judged the decision opened the door to a resumption of large-scale asset purchases.

“The Fed is cognizant the recovery has lost some momentum and it is still willing to intervene,” said Paul Ballew, a former Fed economist and a senior vice president at Nationwide Mutual Insurance Co. in Columbus, Ohio. “We always thought the exit strategy would be challenging. If you’re at the Fed, it’s proven to be more problematic than what you thought.”

Officials directed the New York Fed’s trading desk to reinvest what economists estimate will be $15 billion to $20 billion a month in maturing agency and mortgage-backed securities back into U.S. Treasuries. The purchases will help keep Treasury yields and mortgage costs low and prevent the level of monetary stimulus from shrinking further.

“They are now targeting a balance-sheet level, and the fact they are targeting the balance sheet is new,” said Julia Coronado, a senior U.S. economist at BNP Paribas in New York who worked on the Fed Board staff for seven years. Any further easing “will likely come in the form of a higher balance sheet and investment in Treasuries.”

Stocks Drop

The dollar rose 0.8 percent against the euro today, climbing to $1.3071 at 9:56 a.m. in London. Stocks fell, with the Stoxx Europe 600 Index dropping 0.9 percent and the MSCI Asia Pacific Index losing 1.6 percent. Standard & Poor 500’s index futures decreased 0.9 percent.

Yields on U.S. 10-year notes yesterday dropped to an 18- month low and closed at 2.76 percent in late New York trading, down 7 basis points. A basis point is 0.01 percentage point.

U.S. central bankers came to their August meeting with a series of reports that pointed to slowing growth. U.S. companies added 71,000 workers to private payrolls in July, less than forecast by economists, and June gains were revised down to 31,000. The unemployment rate stayed at 9.5 percent.

The jobless rate has sapped confidence, reducing consumer spending to a 1.6 percent annual rate in the second quarter, about half the average pace in the last expansion. U.S. companies don’t have much room to raise prices in the face of weak demand, keeping inflation low.

Risk Assets

The Fed’s decision yesterday may not succeed in bringing down unemployment even as it supports “risk assets,” said Anthony Crescenzi at Pacific Investment Management Co., manager of the world’s biggest bond fund.

Those jobs “won’t be recovered easily, certainly not by adding a couple hundred billion dollars into the banking system,” Crescenzi said in an interview on Bloomberg Television. At the same time, “low volatility tends to be good for the interest-rate climate. It does push investors out the risk spectrum generally. That tends to be good for risk assets.”

Aeropostale Inc., a retailer to teenagers whose sales rose in July at one-seventh the pace analysts predicted, said changing consumer preferences and a “challenging” retail environment hampered spending. Sales at J.C. Penney Co., a department-store chain, fell 0.6 percent last month.

Committee Statement

“The pace of recovery in output and employment has slowed in recent months,” the Federal Open Market Committee said in its statement yesterday. “Measures of underlying inflation have trended lower in recent quarters.”

The personal consumption expenditures price index, minus food and energy, rose at a 1.4 percent rate for the 12 months ending June, below the 1.7 percent to 2 percent annual rate Fed officials view as preferable, according to their June forecasts.

The Fed left the overnight interbank lending rate target in a range of zero to 0.25 percent, where it’s been since December 2008, and repeated a pledge to keep rates low “for an extended period.”

The risk faced by the Fed is that growth slows to a pace that leaves unemployment high “as far as the eye can see,” said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York. That could increase the risk of deflation, or a general decline in prices that saps consumer spending and corporate profits and increases the value of debt.

‘More Worried’

“It is possible that they are just getting more worried about whether we are getting a rebound and a strong cyclical lift,” Feroli said.

Feroli and other economists said they were puzzled by the Fed’s choice of a $2 trillion target for its portfolio and said the central bank hasn’t explained how such a goal would “help support the economic recovery,” as its statement said.

“There is absolutely zero evidence that if you let the balance sheet run down $10 billion to $15 billion a month that it would be a binding restraint on the economy,” said Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut.

Until now, Fed Chairman Ben S. Bernanke has deployed what he called “credit easing,” using backstops such as the Commercial Paper Funding Facility and purchases of $1.25 trillion in mortgage-backed securities to lean against higher credit costs for home buyers and U.S. corporations as investors shunned risk.

Balance Sheet Swells

The Fed’s total assets, which include loans and securities other than those used for monetary-policy operations, rose to $2.33 trillion last week from $878 billion at the start of 2007. Even so, Fed officials never had a formal target for the balance sheet level.

“They have given us no evidence why quantitative easing works,” Stanley said.

Some observers said yesterday’s decision took them by surprise after Bernanke and other officials in recent weeks maintained their outlook for a pickup in the economy over the next year.

While weakness in housing and commercial real estate will restrain the recovery, and the job market’s “slow recovery” weighs on consumers, “rising demand from households and businesses should help sustain growth,” Bernanke said in an Aug. 2 speech in Charleston, South Carolina.

“It seems like communications is a problem, particularly around turning points,” said Timothy Duy, a University of Oregon economist who formerly worked at the U.S. Treasury Department. “It seems odd that 10 days ago you had a speech that hardly acknowledged the weakness of the recent data.”