

As the economic recovery showed signs of sputtering, at least seven of 17 Fed officials spoke against or expressed reservations about a plan to alter the way the Fed manages its huge portfolio of securities before the move was approved on Aug. 10. Jon Hilsenrath discusses. Also, Jenny Strasburg discusses a Chinese sovereign-wealth fund in talks to invest a large sum of money in a hedge fund devoted to profiting from 'Black Swan' market swoons.




The debate over the decision to keep the Fed's $2.05 trillion stock of mortgage debt and U.S. Treasury holdings from shrinking, described in interviews with several participants, set the stage for a more consequential discussion inside the Fed that remains very much alive: what to do next, if anything, about America's stubbornly weak recovery and troublingly low inflation.

Mr. Bernanke gets an opportunity to elaborate on this crucial and unresolved question when he and other Fed officials gather Friday and Saturday, along with foreign counterparts and a gaggle of academic experts, at the Fed's annual meeting in Jackson Hole, Wyo.

After steering the economy away from another Great Depression, Mr. Bernanke confronts a painfully slow rebound. Unemployment is still high and inflation is uncomfortably low. Fed officials, who spent much of the early part of this year planning for an exit from easy-money policies, have been forced to think about doing more to jolt the economy to life.

Fed officials emphasize they have common objectives despite being deeply divided over what to do next: They seek to avoid either deflation, a broad decline in prices and wages, or an upsurge of inflation. And they share a strong desire to get the economy growing fast enough to sustain a recovery without unusual government support.

The Fed already has cut the short-term interest rates it targets to near zero, vowed to keep them there for an extended period and purchased trillions of dollars in securities, with money the central bank creates, to push down long-term interest rates.

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The most contentious issue now is whether to print more money and buy even more long-term securities, which would expand the Fed's portfolio further. An earlier bond-buying program ended in March.

A decision hinges largely on whether the Fed sees inflation falling much further or if economic growth fails to revive. The Fed and most private forecasters still expect faster growth in 2011, and few economists are predicting outright deflation.

Among the other issues: Should the Fed act quickly, or should it wait for firmer evidence that the economy is truly faltering? And if it does decide to act, should it take small, cautious steps or large, dramatic ones?

Fed officials have divergent views on both issues, and all sides knew that the decision at the Aug. 10 meeting would be widely seen as an indication of which way the Fed was leaning. In the event, it leaned toward action.

Before the meeting, officials at the Federal Reserve Bank of New York, which manages the Fed's portfolio, had grown concerned, according to people familiar with the matter. The Fed's portfolio of mortgage-backed securities was about to begin shrinking much more rapidly than anticipated, as low mortgage rates led more Americans to refinance their mortgages. That in turn meant the mortgage-backed securities held by the Fed were being paid off.

The size of the Fed's portfolio has become one of the central bank's major monetary tools. A shrinking portfolio in the face of slowing economic growth was unwelcome to many officials, including New York Fed President William Dudley. It amounted to prematurely applying the brakes.

Behind Closed Doors

The Fed's vote to alter its portfolio disguised internal disagreements

The New York Fed's markets chief, Brian Sack, had been revising up his estimates of how much the portfolio would contract. In a memo circulated by Mr. Sack's group a few days before the meeting, the estimate was revised up again. In March, the group projected the portfolio would contract by a bit more than $200 billion by the end of 2011. In a memo circulated by Mr. Sack's group a few days before the meeting, the estimate was revised to up to $340 billion. In addition, about $55 billion in debt issued by the mortgage giants Fannie Mae and Freddie Mac that the Fed held would likely be paid off. Taken together, it represented a potential 20% drop in the Fed's holdings in 18 months' time.

"The shrinking of the balance sheet just didn't feel right to me under the circumstances," says Dennis Lockhart, president of the Atlanta Fed, who tends to be in the middle of the road in most Fed debates.

As is the custom, Fed staff in Washington offered the members of the policy-setting Federal Open Market Committee—the five current Fed governors in Washington and the presidents of the 12 regional Fed banks, five of whom have a vote at each meeting—a range of options before the meeting.

Bernanke at Jackson Hole

Every August, the Federal Reserve Bank of Kansas City holds a retreat in Jackson Hole, Wyo., where Fed officials, foreign counterparts and academic experts meet to discuss economic policy. Ahead of this weekend's gathering, see key words and themes from Fed Chairman Ben Bernanke's past keynote speeches.

The declining mortgage portfolio was the focal point of debate. The Fed could allow it to continue going down or it could try to keep it stable by putting the money from maturing mortgage bonds into new securities, either Treasurys or other mortgage bonds. Officials spent very little time discussing the idea of expanding the securities portfolio beyond its current size.

The group was under added pressure because this meeting was scheduled to last a single day, a time frame that was standard before the financial crisis, but that had more recently expanded to two days. And unlike many Fed meetings, there was no clear consensus, either inside the Fed or among the cadre of Wall Street pundits who predict and second-guess Fed policy. To allow more time, the meeting was called for 8 a.m., an hour earlier than usual.

Officials were clustered in two camps. In one camp, Mr. Dudley, and the presidents of the Boston and San Francisco Fed banks, Eric Rosengren and Janet Yellen, were distressed that the Fed was far from its objectives of low unemployment and stable inflation. Unemployment was at 9.5%, above the 5% to 6% range that the Fed considers full employment. Inflation was running at around 1%, below the Fed's informal target of 1.5% to 2%. This camp was more inclined to act.

The other camp was skeptical. Fed governor Kevin Warsh, a former Wall Street investment banker who worked closely with Mr. Bernanke during the crisis and who attends many Washington Nationals baseball games with the chairman, worried that a decision to reinvest mortgage proceeds into Treasurys would confuse investors and lead many to believe the Fed was paving the way to resume major purchases before it had decided to do so. An abrupt change in stance, he argued, could lead the public to believe the Fed was more worried about the economy than it really was.  

Ben Bernanke in July Associated Press

Some officials wanted the Fed to acknowledge the softer economy in its policy statement but hold off on changing the management of the portfolio until there was more clarity on the economy.





"He sees an unusually uncertain time and he puts his Socratic professor hat back on," says one official familiar with the Fed chairman. "He's comfortable with democracy around the Fed. His view is that is going to help him get to a better judgment."

After listening intently, Mr. Bernanke summed up the debate, acknowledged the disagreements, and then said that the Fed shouldn't allow the passive tightening of financial conditions that was being caused by its shrinking balance sheet. In practice, that would mean taking proceeds from nearly $400 billion in maturing mortgage bonds and buying Treasury debt. The Fed also needed to acknowledge the slower growth outlook, he said. The meeting ended later than usual.

The formal vote—9 to 1—disguised the disagreements. Both Mr. Warsh and Ms. Duke voted with the chairman. So did vice chairman Donald Kohn, governor Daniel Tarullo and four of the five regional Fed bank presidents who have votes this year: Mr. Dudley, Mr. Rosengren, St. Louis' James Bullard and Cleveland's Sandra Pianalto. Mr. Hoenig, as he has at every opportunity this year, formally dissented.

Yields on long-term Treasury bonds fell after the announcement, as proponents of the move anticipated. But stocks later skidded, evidence to internal skeptics that the Fed misfired.

"We sent some garbled message about a weaker economy where we wanted to be more accommodative," says Mr. Plosser. "That was confusing and ran the risk of scaring the markets."

Now the internal debate turns to the future, particularly whether to do more, and if so whether to make small or large steps. In March 2009, when the economy was sinking fast, the Fed chose a big step, the move to buy large quantities of mortgages and Treasury bonds. One Fed official, Mr. Bullard of St. Louis, has drawn the attention of his colleagues by loudly advocating smaller steps as the outlook changes to calibrate Fed policy with changes in the economy, an idea that has gotten the attention of many officials.

"I don't think it's likely that the [Fed] would go with some kind of 'shock and awe' where you do some big policy move all at once," Mr. Bullard said in a recent interview.

Others disagree. "I don't see the benefits of these sorts of small fine-tuning symbolic gestures," says Philadelphia's Mr. Plosser. If the deflation threat becomes real, and he says it hasn't yet, then the Fed might need to attack the problem aggressively.

One thing is clear: Mr. Bernanke, though striving for consensus, is determined to avoid mistakes of past central bankers that created devastating bouts of deflation. As a Princeton professor in the 1990s, Mr. Bernanke lectured Japanese officials for being too timid about combating deflation. And in now-famous remarks he delivered as a Fed governor at a 90th birthday celebration for Milton Friedman in 2002, Mr. Bernanke promised the Fed would never allow a repeat of the deflation of the 1930s.

"The worst outcome for him personally would be to let something like deflation get under way on his watch," says Alfred Broaddus, the former president of the Richmond Fed who served alongside Mr. Bernanke from 2002 until 2005. "He will respond forcefully to evidence that the risk of a deflationary process getting under way is rising materially. He won't be ambivalent."

Write to Jon Hilsenrath at jon.hilsenrath@wsj.com