Yellen triggers plan to cut stimulus and avoid disaster: Don Pittis

With deadly earthquakes, hurricanes, floods and fires, thisseems like a season of disasters.

Yesterday the world's most powerful central banker, Janet Yellen,demonstrated that she is determined not to create another disaster in financial markets in spite of a dramatic change in course.

Yellenthrew the switch ona plan to reverse one of the two methods central bankshave used to recharge an economy battered by the 2008 financial storm.

Yellen, the U.S. Federal Reserve chair,has now formally asserted that she will withdrawboth those kinds of monetary boosts to the economy,thestimulus of low ratesand the slightly more complex stimulus of buying up bonds.

Nerve-racking peak

And rather than creating a shock wave likely to tumblestock markets, nowtrembling near a nerve-racking peak, it appears the cautious Yellenhas once again proved her worth as a safe pair of hands.

"The decisions that we've made this year about rates and today about our balance sheetare ones we've taken because we feel the U.S. economy is performing well," Yellen told reporters at yesterday's news conference.

Many Canadians have learned from painful experience about theimpact of interest rates followingthe Bank of Canada's recent increase. Higher rates make money more expensive and, other things being equal, theydiscourage people and companies from taking on more debt.

Yellensaid yesterday thatdespite low inflation, the U.S. expects to continue raising rates with the intention of cooling the economy. While Yellenleft rates unchanged this time,she confirmed expectations of another increase this year and more to come.

• Fed holdskey rate, expects another 2017 increase

But the thing she did announce yesterday, which she seems,so far at least, to have handleddeftly, is the "balance sheet" part. Its effectsare more nuanced.

Perhaps in a time of disasters, a flood analogy would help to explain the Fed's plan.

In the wake of the 2008 market shock the U.S. central bank and others around the world did not just cut interest rates.

The Fed under Yellen's predecessorBen Bernankebegan buying up mortgages and long-term bonds, using money imagined into existence by the central bank,eventually accumulating a huge reservoirof these financialinstruments which they kept on the Fed's books, or "balance sheet."

In normal times the Fed keeps some securities on its booksso that it can use them to intervene in markets to increase stability.

Bond-buying binge

But as a result of the post-2008 bond-buying binge, somewhat confusingly called "quantitative easing," the central bank has nearly $4.5 trillion USworth of bonds and mortgage-backed securities dammed up in its reservoir. Some economists worry such a vast lake of bonds isdistorting the market and is in danger of distorting it more if it gets out suddenly.

Now Yellenand her team want to at least partiallydrain the reservoir. But they are anxious not to create a flood.

In 2013 Bernankecaused a briefmarket panic dubbed the "taper tantrum" by merely hinting he was going to gradually stop adding to the reservoir.

But this time Yellenseems to have chosen her strategy and her timing well.

Without putting the plan into effect, the Fed laid out her hydrological project carefully months in advance.

Avoiding a tailspin

The plan was to gradually releasemeasured amounts into the spillway, so the financial lakes and rivers downstream could absorb the discharge without overflowing their banks and creating a dangerous floodthat would drive interest rates up sharply and waterlog markets.

The Fed plan is not to sell bonds. Instead,when bonds in the portfolio reach their maturity date and pay back their principal, the central bank will simply not buy new ones, thus reducing the total amount on itsbooks.

Yesterday Yellen announced theplan is to start in October, letting $10 billion worth drain out of the reservoir and into the normal economy. Then after that, the monthly discharge will gradually increase in a series of planned steps, allowing markets to learn how to absorb the outflow.

If the economy continues to be stable and inflation begins to kick in as the Fed's advisory committeeforecasts, then a slight rise in rates caused by lowering the reservoir will be just what the doctor ordered.

• Reluctant borrowers force-fed Dr. Yellen's bitter pill

As Yellenexplained yesterday, if a fine-tuning of stimulus is needed, either up or down, the Fedstill has the power to adjust interest rates.

"If there is some small negative shock our first tool, our most important and reliable tool, would be federal funds rate," she said.

Effectively, Yellensays, the central bank does not want to adjust the plan and start buying bonds again except in the case of "a significantshock that's a material deterioration to the outlook."

That is the statement that ties her hands.

The Fed can change itsreservoir-draining plan if necessary, but Yellenlikely knows tinkering with the strategy now that it's in place wouldsignalmore uncertainty and instability, with the danger of provoking adisaster she is anxious to avoid.

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