The Outlook
Tough Question for Fed: Time to Act?
Officials Could Decide This Week Whether to Begin Pulling Back on Bond Purchases
By Pedro Nicolaci da Costa and Jon Hilsenrath
Updated Dec. 16, 2013 3:25 p.m. ET
Federal Reserve officials face a delicate decision at their policy meeting this week, with stronger economic figures and a Washington budget deal adding fuel to the debate over whether to pull back on their signature bond-buying program.
Fed Chairman Ben Bernanke in June set out a three-part test—based on employment, growth and inflation—for reducing the $85 billion in monthly bond buys. He said the Fed's policy committee wants to see progress in the job market, supported by improving economic activity and an inflation rate rising toward its 2% target.
Recent data show progress on the first two criteria, but not on the third. The inflation rate has been persistently below the Fed's objective and reflects weak consumption and wage growth, which bode poorly for the economic recovery. Fed officials will likely differ on whether the gains overall are good enough to clear Mr. Bernanke's hurdles.
Improving employment numbers appear to broadly meet Mr. Bernanke's first benchmark. Employers added 203,000 jobs in November, which means job growth averaged 195,000 a month in the past 12 months. That is well above the pace of around 150,000 monthly in the year ended in September 2012, when the bond-buying program was launched.
Meanwhile, the unemployment rate fell to 7% in November from 7.8% in September 2012. That is much better than the Fed's forecast in September 2012 that the jobless rate would be between 7.6% and 7.9% by the end of this year. That could be called a substantial improvement in the labor-market outlook since the program began.
The brighter outlooks come with important caveats. The unemployment rate has fallen in part because of people leaving the labor force, which means they are no longer counted as jobless. U.S. gross domestic product jumped at a 3.6% annual rate in the third quarter, but the increase was driven largely by a buildup in inventories.
"We expect the FOMC to question the sustainability of the pickup in growth and hiring and thus to refrain" from cutting the bond buys, said Laura Rosner, economist at BNP Paribas, referring to the policy-setting Federal Open Market Committee.
One argument against taking action this week is that inflation isn't moving toward the Fed's target. If anything, it is going the wrong way. The Fed's preferred measure—the Commerce Department's personal consumption expenditures price index—fell to an annual clip of just 0.7% in October, less than half the 2% target rate.
"My sense is that inflation will move back toward 2% over the next year or two, in part because measures of expected inflation remain well contained," Richmond Fed President Jeffrey Lacker said in a recent speech. "This is not a certainty, however, and I believe the FOMC will want to watch this closely."
With mixed results on Mr. Bernanke's three-part test, other factors could play into the committee's decision this week.
The Fed has another condition for continuing the bond-buying program, which is aimed at holding down long-term rates to spur growth and hiring. Officials say they will halt it if the costs of continuing exceed the benefits. Policy makers worry the costs—such as the risks of financial bubbles or other market disruptions—rise as their bond holdings grow. They also believe the benefits diminish over time.
Fed officials haven't explained how they will know when they have reached the point where costs outweigh benefits. They aren't there yet, Fed Vice Chairwoman Janet Yellen said last month, at a hearing on her nomination to become Fed chairwoman in February. The Senate is expected to confirm her this week.
Because of this trade-off, Fed officials seem inclined to move away from the bond-buying approach as a tool for influencing long-term borrowing costs and rely more on providing verbal guidance about their plans for short-term rates. The Fed has said it won't raise short-term rates until the unemployment rate falls to at least 6.5%, as long as inflation is contained.
Of 43 economists polled recently by The Wall Street Journal, just 11 expected the Fed to cut its bond purchases this week, while 30 said it would wait until early next year.
Whenever the Fed starts winding down the bond program, it is clear it is on the way toward removing a tool that has been the market's crutch for more than a year. Mr. Bernanke might start the process, but it will be Ms. Yellen's job to finish it.
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