No Light Ahead as Fed Holds Rates for Two More Years
Business + Economy

No Light Ahead as Fed Holds Rates for Two More Years

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By pledging  to keep its target overnight interest rates close to zero for the next two years,  Ben Bernanke and other Federal Reserve Board officials signaled on Tuesday their harsh assessment that economic growth will remain paltry and the nation’s 9.1 percent  jobless rate  will come down little between now and the 2013, well past next year’s election.

The central bank’s commitment to hold the miniscule interest rates steady for at least the next 24 months is unprecedented, and comes in response to an extraordinarily bleak economic outlook and the financial market turmoil that followed the downgrading of the U.S. government AAA credit rating.  

The policy-setting Federal Open Market Committee also discussed other possible actions--such as resuming purchases of longer-term Treasury securities (QE3)--which might “promote a stronger economic recovery in a context of price stability.”

One day after its biggest retreat since the December 2008 financial crisis, a jittery Wall Street looked hopefully to the Fed for new initiatives to boost the economy, and momentarily showed disappointment as the market averages began to dip in mid-afternoon. But the markets closed strong with the Dow Jones Industrial Average soaring 429 points and making up much of the ground lost on Monday. 

With the White House currently struggling to come up with new approaches to stimulating a near moribund economy, President Obama will have to rely on the Fed to some degree to help get the economy moving again and bring down unemployment before the 2012 presidential and congressional elections.

The Fed’s announcement drove yields on Treasury securities to new lows, providing further evidence that investors had lost little confidence in the U.S. credit rating despite the S&P downgrade. Two-year notes were so popular with investors that the yield dropped to just 0.17 percent, and 10-year note yield—which heavily influence rates homebuyers pay on 30-year fixed-rate mortgages—were 2.18 percent.

Until today, the FOMC statements had routinely said the key rate target would be kept close to zero for “an extended period.” And as recently as June, committee participants were discussing details about when they could begin to tighten their policy stance as the economy strengthened.

“I think they gave an honest read on the economic outlook,” said Mickey Levy, chief economist at Bank of America. “They acknowledged that the economic weakness is not just due to temporary factors, and as they say, the risks are to the downside. The market is dissatisfied because there was no immediate renewal of quantitative easing. My frustration is that the markets look at the fed expecting them to fix all problems.  And what’s going on now is beyond the scope of traditional monetary policy.”

F. Ward McCarthy, chief financial economist at Jeffries Group, said he thinks that more Fed action is on the way. "Given the downgrading of the economic outlook and inflation risks, the Fed will follow with additional action soon,” he said.  The most likely would be some effort to make sure long-term rates stay low, such as a resumption of quantative easing in some form, according to McCarthy.

The decision to commit to not increasing the target until mid-2013 was far from unanimous. While there were 10 voting FOMC members, only seven of them, including Bernanke, agreed to the language. Three presidents of regional Fed banks, Richard W. Fisher from Dallas, Karayana Kocherlakota of Minneapolis and Charles I. Plosser of Philadelphia, dissented. The trio wanted to stick with “extended period.”

Charles L. Schultze of the Brookings Institution, a former chairman of the Council of Economic Advisers, said he was surprised by the FOMC’s willingness to make even a conditional commitment to a rate target for two years.

“The economic slowdown is serious in one sense but it hasn’t lasted very long, and they didn’t choose to say that, which they could,” Schultze said. “Meanwhile, they went out of their way to calm anybody’s fear about what food and oil prices are doing. I think what they were telling us is they are really interested in finding a way to improve the economic outlook.”

Since the FOMC’s last meeting in June, the Commerce Department has revised its estimates of economic growth to only about a 1 percent annual rate. In its statement, the committee also said labor market conditions have deteriorated in recent months, household spending has flattened out and the housing market is still very weak. On the other hand, business investment in new plants and equipment is still expanding, it said.

As Bernanke has said repeatedly, the Fed seeks to make policy based on what officials expect to happen in the next year or two, not what’s happening in the current quarter. That is what makes the Fed’s unprecedented two-year commitment so alarming. It’s not the current turmoil in financial markets with stock prices tumbling—though all around the world they regained a small bit of the lost ground today—that has the Fed majority worried. It’s that growth will remain weak, and as the statement said, “Downside risks to the economic outlook have increased.”