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The Federal Reserve is likely to raise interest rates before its bond-purchasing program is phased out completely if faced with uncomfortable levels of inflation, though its communication task will be simplified if it can finish tapering first, former top Fed officials told MNI.
Most investors presume the Fed would not raise rates while still buying Treasuries and agency mortgage-backed securities, based on the post-financial crisis playbook. But some former officials anticipate economic conditions will warrant interest rate increases as early as 2022 following a tapering decision to be delivered toward the end of this year, leaving little or no time separating the two processes.
"I can well see, and indeed expect, some movement on rates before they finish expanding the balance sheet," former Fed Vice Chair Alan Blinder said in an interview. "Finishing the taper before raising rates is the less likely option."
An announcement on tapering could come in September or November, followed by a rate hike in 2022 if growth keeps up at a rapid pace and inflation does not quickly ebb to 2%, Blinder said. Raising interest rates while still adding accommodation via the balance sheet would be "hard to explain, but it won't stop them," he said. "They'll say something like: We have a portfolio of instruments and we'll adjust them to the needs of the economy."
QE A SECONDARY TOOL
The Fed regards asset purchases as less precise and effective than interest rates, its most potent monetary policy tool, influencing the entire economy beyond certain financial intermediaries. Tapering would in its view be a fairly small move in terms of its overall policy settings.
It would not hesitate to raise rates while securities purchases still continued, should the committee deem that appropriate, despite the fact that QE makes most sense when rates are at zero, officials said.
Naturally it would be easier for the Fed to communicate its tightening policy if it is not still adding some accommodation via QE, but inflation may not allow it that luxury.
"We've got two not-very-precise dials we can turn, both of which modulate the amount of support to economic activity, and what matters is the overall amount of support monetary policy is providing, the combination of the two dials together," former Fed Board research director David Wilcox told MNI. "There's no reason to turn one to off before adjusting the other one."
SPEEDING UP TAPER
The timing of interest rate increases also has implications for the pace at which the Fed winds down its purchases, the former officials said. If the Fed needed to raise rates while still adding assets, it could consider speeding up its QE tapering, but the bar would be high.
"They've always treated asset purchases as a slow-moving object, simply to allow the market to better absorb the flow of Treasury sales and make things very predictable for market institutions," said former New York Fed research director Jamie McAndrews.
"They want to put securities on a predictable course, and if they need to remove accommodation, they could raise rates wherever they are in the tapering process."
The option to quicken the reduction of purchases is "very plausible" as well, depending on how much faster it would need to be, former Fed Governor Larry Meyer told MNI.
"It would be nice to end tapering before you hike rates, but it's not a requirement. When you meet the condition to lift off, you lift off. End of story."