Focus sharpens on Fed chairman

In the main hall at the Federal Reserve’s gathering in Jackson Hole, Wyoming, this weekend the theme will be the next decade of macroeconomic challenges, but in the corridors of the mountain resort all the talk will be of the next six months.

A steady decline in the economic data, coupled with sharp falls in the markets since the Fed’s surprise move on August 10 to stop shrinking its balance sheet, mean a ferment of interest in what the US central bank will do next.

The spotlight on Ben Bernanke, Fed chairman, will therefore be even brighter than usual when he opens the conference on Friday morning with a half-hour speech on the economic outlook and the Fed’s policy response.

To add to the drama, the Bureau of Economic Analysis is likely to highlight the faltering recovery just before Mr Bernanke stands up to speak, by revising second-quarter growth sharply downwards. Weak numbers on business inventories and construction spending – plus higher net imports than previously thought – mean that growth is set to be cut from the previous estimate of 2.4 per cent to as little as 1 per cent.

One priority for Mr Bernanke will be to explain the move to reinvest the proceeds of repayments from the Fed’s portfolio of mortgage-backed securities into Treasury bonds. He will want to emphasise that the Fed has not panicked about the outlook.

Most Fed officials agree with what James Bullard, president of the St Louis Fed, said recently: “The US outlook has been downgraded, but still remains positive – continued expansion is the most likely course going forward.”

Instead the Fed was concerned that its balance sheet might shrink faster than expected because lower bond yields have raised the incentive for US citizens to repay their mortgage. “This kind of fluctuation in prepayments is at the heart of the FOMC’s [Federal Open Market Committee] new policy action in August,” said Narayana Kocherlakota, president of the Minneapolis Fed.

Some Fed officials thought that markets might fear a downward spiral: a worsening economic outlook that caused bond yields to fall, leading to higher mortgage prepayments, a shrinking Fed balance sheet, tighter monetary conditions and so a worsening outlook.

Most members of the rate-setting FOMC agreed that it made sense to eliminate this risk, and that given the weaker outlook, the Fed should no longer tighten policy by letting its balance sheet shrink. The decision was contentious, but rather than two warring camps, there was a range of views.

Only a relatively small portion of the FOMC, such as Kansas City Fed president Thomas Hoenig, felt that conditions did not justify the move. Others feared that the markets might misinterpret the action or were concerned about distorting bond markets

While the FOMC agreed to move policy to neutral, many members still set the bar for aggressive further easing quite high, because they are concerned about its effectiveness, risks and costs. They do not see the August move as the first step in a campaign of easing and think the next move should depend on the data. Some members, for example, would look for evidence of a fall in inflationary expectations.

In his speech Mr Bernanke is likely to discuss the pros and cons of further easing actions that the Fed could take. He is unlikely to rule anything out, because if the economy does worsen, the Fed is likely to try a bit of everything. But he may reflect a rough consensus in the Fed that the main tool would be restarting asset purchases.

What remains a subject of hot debate is how and on what scale asset purchases would be carried out.