Federal Reserve officials are zeroing in on a strategy to begin winding down their $4.5 trillion portfolio of mortgage and Treasury securities, possibly later this year, as part of their broader effort to drain reservoirs of stimulus out of the financial system.
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Under the emerging strategy, the central bank would raise short-term interest rates two more times in 2017 and then potentially pause rate increases, perhaps late in the year. That would allow Fed officials to start winding down their portfolio of securities in a gradual and measured way to assess how markets handle the moves before resuming additional rate increases in 2018, according to interviews and recent public statements from officials.
The strategy depends on whether the economy keeps performing as expected, and it depends on whether Fed Chairwoman Janet Yellen can build a consensus among policy makers about how to proceed. No decisions have yet been made.
On Friday, Fed officials got news they are on the right track. The economy reached an important milestone when consumer inflation in February exceeded the Fed's 2% target after undershooting it for nearly five years.
The personal-consumption expenditures price index, which is the Fed's preferred inflation gauge, edged up in February and climbed 2.1% from a year earlier, the Commerce Department said Friday. It was the largest annual gain for the price measure since March 2012.
Officials also closely watch so-called core inflation, which excludes volatile food and energy prices. That gauge rose 1.8% from a year earlier, matching the highest levels touched since 2012, though still a bit below the 2% mark.
Inflation's rise is a signal that slack in the economy in the form of excess industrial capacity, high unemployment and empty buildings has diminished, removing the forces that have weighed on consumer prices for several years.
Firmer inflation gives Fed officials leeway to follow through with plans to raise rates and reduce bondholdings.
The central bank has been telegraphing interest-rate increases for months -- it raised rates by a quarter percentage point at its December and March meetings -- but has been noncommittal on how it will handle its bond portfolio.
The holdings are often referred to as the balance sheet and grew from less than $1 trillion before the financial crisis to $4.5 trillion through asset-purchase programs aimed at lowering long-term interest rates and boosting economic growth. Shrinking the balance sheet could cause long-term rates to rise.
"When we decide to begin to normalize the balance sheet, we might actually decide at the same time to take a little pause in terms of raising short-term interest rates," New York Fed President William Dudley said in an interview on Bloomberg TV Friday.
Critics say the large portfolio has distorted market functioning. The Fed has long said it wants to shrink the balance sheet as the economy heals. One way to reduce it is to allow securities to mature without using the proceeds from maturing securities to buy new ones, as it does now.
The details are still being worked out. Fed officials held a discussion on the balance sheet at their March policy meeting. Staff economists have started work on a paper that could help forge consensus over the myriad technical details that have yet to be sorted out, including whether to slow reinvestment in Treasurys and mortgage bonds simultaneously or to reduce the holdings of one before the other.
How it proceeds is of great importance to market participants. In 2013, when the Fed signaled it would stop adding to the portfolio, stocks fell, interest rates rose and emerging stock and bond markets sank -- an event known as a "taper tantrum" on Wall Street, driven by investor worries about the implications of a less accommodative Fed.
The challenge for the Fed is that there is no playbook for reducing the size of its holdings. Officials want to make changes slowly and with extreme care to avoid roiling markets.
Officials haven't decided how to manage the runoff of assets, but a gradual path that tapers the pace of reinvestments over several months rather than ceasing them altogether could allow for that least disruptive approach.
The goal is that any policy changes on slowing reinvestments are "just going to be running in the background," Mr. Dudley said. "We would want to do this in a way that was...not a big deal for the markets."
The Fed's balance sheet has grown to around 23% of U.S. gross domestic product from around 6% before the financial crisis.
One ancillary advantage of communicating any plan for the balance sheet later this year is that it would remove uncertainty associated with a possible change in leadership at the Fed in 2018, when the terms of Ms. Yellen and Vice Chairman Stanley Fischer expire.
The shifting inflation trend is an important factor as the central bank decides how to proceed.
Inflation's move above 2% confirms the sharp drop in oil prices that began in mid-2014 was a temporary shock, "not a sign of fundamental weakness in the global economy," said Laura Rosner, an economist at BNP Paribas. "A higher rate of inflation suggests that activity is growing at a healthy pace and downside risks have diminished."
Some U.S. manufacturers have seen costs for commodities rise recently, and that's affecting their pricing strategies. "Raw material prices, particularly steel and zinc, have continued to increase and we expect to be successful in passing through cost increases to the market," Richard Parod, chief executive of Lindsay Corp., an Omaha, Neb. maker of irrigation systems, told investors Thursday.
But there appear to be limits to how much higher inflation will go.
Mooyah, a chain of burger and shake restaurants based in Plano, Texas, finds it difficult to pass higher wages and rents on to customers in the form of higher prices in the crowded food-service segment.
"Labor costs have increased 5% to 10%" partly due to higher minimum wages in several states, Mooyah Chief Operating Officer Michael Mabry said. "But you can't raise menu prices by that amount in this environment." The chain recently lowered prices on its least expensive items, small fries and drinks, in an effort to increase traffic.
The Commerce Department's inflation gauge has increased steadily since August 2016, when the annual increase was 1%. Energy prices were the primary driver, rising each month from September through January. But energy prices fell 1.3% in February. The decline could signal inflation is unlikely to rise much further.
The Fed projects 1.9% inflation by year-end. March inflation data from Europe suggests inflation pressures remain modest. The European Union's statistics agency said Friday consumer prices were 1.5% higher in March than a year earlier, a fall in the rate of inflation from 2% in February. In Japan, prices firmed in January and February. Prices there fell in 11 out of 12 months in 2016.
One important wild card is the behavior of U.S. consumers. Inflation-adjusted household spending declined 0.1% in February after falling 0.2% in January, according to the Commerce Department. It was the largest two-month decline since the recession ended, at least partially reflecting unseasonably warm weather depressing spending on utilities.
A slowdown in consumer spending, which accounts for about two-thirds of U.S. economic activity, could prove to be a new headwind to growth which damps inflation once again and derails the Fed's plans.
Macroeconomic Advisers on Friday revised its forecast for a first-quarter gain in gross domestic product to a 1% annual rate. The Atlanta Fed's GDPNow model on Friday lowered its forecast for first-quarter growth to a 0.9% pace. The economy expanded at a 2.1% rate in the fourth quarter, in line with the pace of the overall expansion.
After resorting to unusual measures to spur the economy after the crisis, the Fed is now "trying to keep the economy on a sustainable basis," said San Francisco Fed President John Williams in a Wall Street Journal interview on March 23.
"We really are switching over to trying to just keep this economy on track," he said. "Not too hot, not too cold and just to get [inflation] to 2%, which I think is mission number one right now, and keep inflation there."