Image by Getty Images via @daylife  On August 9, the Federal Reserve took the unprecedented step of explicitly committing to its current interest rate policy for a particular time frame. Or did they?  The policy-setting Federal Open Market Committee changed the language in its statement dealing with the time span for which the benchmark federal funds rate will stay at “exceptionally low levels.”  Rather than the “extended period” language it has maintained since dropping the target for the rate to 0-0.25% in December 2008, the FOMC said “economic conditions are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.”  In the wake of the statement, much of the focus was on how Fed Chairman Ben Bernanke had tied his hands and capitulated to a turbulent market. The story goes that by promising to keep rates low until June 2013, the Fed was doing everything it could to limit yields on fixed-income assets and push investors into risk assets like equities.  That may not be entirely accurate. In a note following the meeting, High Frequency Economics chief U.S. economist Ian Shepherdson pointed out that while Bernanke may have tied his hands, he did so loosely.  At first blush, Shepherdson writes, “the prospect of low rates for the next two years looks like either a welcome shift to putting the Fed’s own forecasts at the forefront of policymaking or a reckless hostage to fortune.” Traditionally the Fed has used lagging indicators like unemployment to spark turning points in monetary policy, making it a “slave to the data.”  What happens, Shepherdson wonders, if the economy picks up and recession fears turn out to be overblown? Is it inconceivable to think that the Fed would reverse course? No, it is not, he concludes, and as such warns that “it is dangerous for investors to assume that no changes in rates or the Fed’s balance sheet are possible until after 2013.”  So in reality, while Bernanke’s latest move appears to have him handcuffed, he’s also holding the key and could easily make like Harry Houdini to change direction if needed. The first shift could come at this week’s economic symposium in Jackson Hole, Wyo., where a growing number of market watchers expect a hint that changes are coming to the Fed’s balance sheet strategy.  Back in 1961, the Fed conducted “Operation Twist,” a move that targeted the longer end of the Treasury market to flatten the yield curve. Barclays Capital’s head of U.S. equity strategy Barry Knapp expects Bernanke to discuss a similar maneuver at Jackson Hole, while stopping short of signaling any additional asset purchases for the time being.  The first Operation Twist was tied to worry of a run on gold but the new version, Knapp says, would be aimed at lowering long-term interest rates without a large-scale purchase. The method would be to redirect the investment of proceeds from maturing assets on the Fed’s balance sheet toward longer-term Treasuries rather than short-term notes, in the hope of having the desired effect without triggering another spike in commodity prices like the one that accompanied the second round of quantitative easing (QE2) formally launched in November 2010 (but tipped by Bernanke at the Jackson Hole meeting last August).  So between leaving himself a trapdoor on interest rates if the economy grows stronger in the coming quarters and potentially attempting to impact long-term rates without an official QE3, it certainly seems as if Bernanke will try to pull a rabbit out of his hat if it might help avoid a slide back into recession.
Pledge to keep rates low, potential for operation twist are the Fed chief's effort to avoid painting himself into a corner.