Friday, February 12, 2010

Goldman Sachs Tells Fed To Start With Rate Hikes

Most handicappers believe that when the Federal Reserve starts to tighten policy, it will begin by moving assets off its balance sheet and follow that with interest rate increases.

Goldman Sachs‘ economists aren’t so sure after congressional testimony by Fed Chairman Ben Bernanke this week. The bank now believes the sequence of the central bank’s exit could be the opposite of the consensus view.

The Federal Open Market Committee “would do its successors a great favor by making the first step of monetary tightening an interest-rate increase instead of a reserve drain,” Goldman economist Ed McKelvey told clients. He cautioned this is a very long-term call, because “we don’t expect or advocate (rate hikes) anytime soon–not in 2010 and probably not in 2011 either.”

The key to Goldman’s argument is a power gained by the Fed in late 2008. Since that time the Fed has had the ability to pay banks interest on the reserves they hold at the central bank. Policymakers believe this tool gives them considerable control over financial system liquidity, as banks park reserves at the Fed in pursuit of guaranteed returns. Officials say the interest on reserves power means huge levels of bank reserves aren’t inflationary, because while banks may be flush with liquidity, it’s not being put into the broader economy.

In his testimony Wednesday, Bernanke said that the interest on reserves tool stands a good chance of supplanting the overnight fed funds rate as the central bank’s focus in a coming tightening cycle. Instead of targeting the funds rate–currently close to zero percent–the Fed would state its new interest on reserves rate target. Bernanke also said the Fed may set targets for bank reserve levels as well, in another departure from the current regime.

The way Goldman sees it, tightening policy this way would be as good as efforts to drain liquidity by asset sales. Interest on reserves should control the balance sheet’s inflationary potential as well as getting securities off the Fed’s books, either by selling or temporary means. “In the absence of either significant inflation expectations –on the part of consumers as well as traders–or a sudden increase in bank lending, we think the FOMC should resist pressures to drain reserves in significant volumes,” McKelvey wrote.

Many economists expect the Fed to follow a different path. They believe that the Fed wants to unload assets before hiking short term rates. Comments from some central bankers support the view. The argument goes it will take some time to shrink a more than $2 trillion balance sheet, so starting there makes sense.

St. Louis Fed President James Bullard said in media interviews this week asset sales could start in the second half of the year, with interest rate hikes put off until 2012.

Goldman’s interest rate outlook is different from many others on Wall Street, who reckon interest rate hikes could come at some point over the latter half of the year. With the economy recovering modestly, there’s a growing appetite to see monetary policy back away from levels set during the darkest days of the financial crisis. Short-term rates could rise a percentage point or two and still remain stimulative of growth, many economists believe.


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