As Bernanke era nears end this week, Fed is likely to pull back further on economic stimulus

WASHINGTON – Just as Ben Bernanke prepares to turn the chairmanship of the Federal Reserve over to Janet Yellen, global markets are on edge over the prospect that she’ll extend a policy he began: a steady pullback in the Fed’s extraordinary economic stimulus.

Managing a slowdown in the Fed’s bond purchases without roiling markets will pose a tough early test for Yellen, who succeeds Bernanke as Fed chair next week. The Fed’s bond purchases have been intended to keep long-term loan rates low to spur spending and economic growth.

Investors have been nervous in part because a pullback in Fed bond buying will likely mean higher rates. Borrowing could weaken as a result. Many also fear that higher U.S. rates will lead some bond investors to move cash out of emerging markets and into the United States to seek higher returns. That fear has depressed currency values in emerging economies.

Once the Fed ends its meeting Wednesday, it’s expected to announce an additional $10 billion cut in its monthly bond purchases. Last month, the Fed said it would start reducing its monthly purchases from $85 billion to $75 billion. It decided to pull back mainly because of evidence the U.S. economy is strengthening and needs less support from the Fed.

Analysts expect the Fed to stick with that policy despite the turmoil in overseas markets, which has battered the currencies of Argentina, Turkey, Russia and other emerging economies. Those economies had previously enjoyed an inflow of investor money.

“Now, those countries are having to deal with a reversal of those flows,” said David Jones, chief economist at DMJ Advisors and the author of a new book on the Fed.

Jones see the market turbulence as a “perfect illustration of the tricky transition that Yellen will have to manage” as the Fed winds down the programs it put in place after the financial crisis erupted in 2008.

Still, he doesn’t think the Fed will diverge from the pace of its bond-buying reductions unless market turmoil begins to slow the U.S. economic recovery.

“As long as they see a strengthening economy and sustained improvement in labour market conditions, they will continue to taper bond purchases,” Jones predicted.

Bernanke will end his tumultuous eight-year tenure at the Fed — officially, at the close of business Friday — amid tentative signs of a stronger U.S. economy. Employers created only 74,000 jobs in December, far below the 214,000 average of the previous four months. But many analysts think the lacklustre December total marked a temporary pause or a statistical aberration.

“The preponderance of evidence shows that the economy is continuing to recover,” said David Wyss, a former Fed economist and now an economics professor at Brown University.

Throughout 2013, the Fed bought $85 billion a month in Treasury and mortgage bonds to try to keep long-term rates down to stimulate borrowing by businesses and consumers.

Bernanke’s first mention of a pullback in bond purchases, in mid-2013, triggered a mini-panic in the stock market. Afterward, the Fed stepped up its efforts to assure investors that a pullback in purchases didn’t mean the Fed would soon raise the short-term rates it controls.

The Fed strengthened that commitment after its December meeting: It said it would likely keep its benchmark short-term rate at a record low near zero “well past” the time unemployment falls below 6.5 per cent. The rate is now 6.7 per cent.

Since the recession ended in June 2009, economic growth has remained subpar. Analysts are forecasting a brighter 2014, in part because the federal government will impose less drag this year. Last year’s tax increases and spending cuts slowed growth, leaving the economy muddling along at a tepid rate of around 1.8 per cent. Analysts believe growth this year could top 3 per cent, giving the Fed room to scale back its support.

One other reason no surprise is expected from the Fed this week is that it’s undergoing a leadership transition. When Yellen, now vice chair, takes over next week, she’ll become the first woman to lead the Fed in its 100-year history.

Even before she takes over, the central bank will have four new voters from among 11 Fed regional bank presidents whose votes rotate each year.

Kansas City Fed President Esther George dissented seven times last year over her concern that the Fed’s bond buying could destabilize financial markets and unleash high inflation. George doesn’t have a vote this year. But two others who do — Charles Plosser, head of the Philadelphia Fed bank, and Richard Fisher, head of the Dallas Fed bank — are, like George, considered inflation “hawks.” Plosser and Fisher might dissent if they feel the Fed isn’t moving fast enough to pare its bond purchases.

The two other new voters are Minneapolis Fed President Narayana Kocherlakota, who has favoured keeping rates low, and Cleveland Fed President Sandra Pianalto, a moderate who backed Bernanke’s policies.

Pianalto plans to step down this year. And President Barack Obama has nominated two new members to the Fed’s board. If confirmed by the Senate, Stanley Fischer, former head of the Bank of Israel and a one of Bernanke’s former college professors, would become vice chair. And Lael Brainard, a top Treasury official in Obama’s first term, would become a Fed governor. Both are viewed as supporters of the Bernanke-Yellen approach to rates.