Four years into a period of unprecedented monetary easing, policymakers are beginning to contemplate what it will take to reverse course. By Glenn Somerville, Associate Editor May 10, 2013 When will the Federal Reserve pull the plug on the ultra-easy monetary policy that has driven its balance sheet to record heights? Not before year-end and possibly not until well into 2014, given the economy’s continuing slow recovery and the current low rates of inflation.See Also: When Will Interest Rates Head Up? The U.S. central bank cut official interest rates, in effect, to zero in late 2008, amid the financial crisis. Since then, in a further bid to spur recovery and wrench down unemployment through successive rounds of “quantitative easing,” it has bought more than $2.5 trillion in long-term bonds, infusing liquidity into the economy. Sponsored Content In the process, the Fed’s balance sheet has swollen to $3.3 trillion and continues to rise by $85 billion a month, prompting questions about when and how the Fed will unwind that bulging portfolio. As Sung Won Sohn, economics professor at California State University’s Channel Islands campus, predicts, the process will take place slowly, in gradual stages, allowing the Fed to reverse course if it deems the economy to be doing too poorly. “I don’t think we’ll see the first hike in rates before late 2014 or into 2015,” says Sohn. Advertisement The key question is, how does the Fed go about returning to a “normal” monetary policy once policymakers decide the time has arrived? The first step will be to cut back bond-buying activities, likely to about half the current monthly pace (to $40 billion in long-term Treasuries plus $40 billion in mortgage debt). It’s possible, however, that the Fed might stage the reductions in smaller increments, over an extended period of time, if policymakers decide a large cutback might be disruptive to markets. The gradual approach would also give the Fed even more flexibility for changing course if the economic winds shift. The next likely step will be to stop replacing securities in the Fed’s existing portfolio, allowing them instead to simply roll off the balance sheet as they mature, gradually reducing holdings. Once that strategy has been set in motion, if economic activity remains stable and improving, the Fed will begin selling off securities by offering them to investors in financial markets. Only then is the central bank likely to begin hiking interest rates. That will require a normally functioning economy with sufficiently abundant jobs, spurring demand that is robust enough to handle higher credit costs. Also, prices must be rising swiftly enough to warrant costlier borrowing charges as a dampener on potential inflation pressures. Advertisement It’s a fairly high bar. The Fed has pledged to keep its target interest rate at or near zero as long as the jobless rate exceeds 6.5%, and inflation is projected to be no more than a half percentage point above the central bank’s long-term target of 2%. The national unemployment rate in April, 7.6%, was well above that jobless target and inflation, as measured by the Personal Consumption Expenditures price index, is only about half the target rate, with no signs of accelerating. So what will it take to lead the Fed to start reversing its unconventional policy approach? Policymakers have offered some hints about the measures of activity they are monitoring, without being specific. And analysts note that some of the necessary conditions are fairly easy to guess. “Employment rising for three consecutive months at a threshold of 200,000 a month or greater is one of them,” notes Steven Ricchiuto, chief economist at Mizuho Securities USA, adding that there would have to be a significant improvement in the labor market for the Fed to act. Much heftier job creation also is the first condition that Stuart Hoffman, chief economist for PNC Financial Services Group Inc. in Pittsburgh, says must be met. “You likely need to see new-job creation averaging above 200,000 for a three- or four-month stretch,” he says. So far in the first four months of 2013, monthly employment gains have averaged nearly 196,000 but haven’t been consistent. And the unemployment rate remains well above the Fed’s target. Advertisement Other signposts important to the Fed include a longer workweek, since more hours worked typically are associated with increased production, leading to more hiring. The current 34.4-hour workweek is up from 33.6 in mid-2009, when the economy was in the doldrums, but it’s still only at about a 2006 level. Policymakers will also watch real disposable personal income, which remains about 2% lower than in 2008 on a per capita basis. That’s not an encouraging sign because consumer spending fuels about two-thirds of national economic activity, and shoppers can’t spend if they’re not earning. Moreover, the odds favor softer growth in the second and third quarters, as the economy copes with uncertainty, stemming from reduced government spending and political dueling over everything from the debt limit to long-term budget deficits. By late this year, however, momentum should begin building in the economy. It isn’t likely to be vigorous enough to prompt Fed policymakers to take the first steps this year. It’s even possible, as the Fed has acknowledged, that with price increases weaker than it feels are needed to grease the wheels of long-term growth, the central bank will continue to push up its aggressive bond-buying program before it begins to take it down.