Will Federal Reserve Tactics Help the Ailing U.S. Economy?

After the Federal Open Market Committee (FOMC) met on August 9, the Federal Reserve announced that it anticipated the federal funds rate to remain “exceptionally” low until mid-2013, citing a slower-than-expected recovery, high unemployment, and increasing downside risks to the economy.1 Initially, stocks dropped in reaction to the Fed’s dismal outlook, but by the end of the day the Dow Jones Industrial Average rose nearly 4%, seemingly in response to anticipated future actions. Investor demand also pushed up bond prices, and yields on treasury bonds dropped before moving back up slightly.2

On September 21, the Federal Reserve decided to act further to help support the economic recovery by attempting to lower long-term interest rates. In a program dubbed “Operation Twist” by the media, the Committee plans to sell $400 billion in short-dated Treasuries (three years or less) and to purchase an equal amount of Treasuries with remaining maturities of six to 30 years.3 Immediately after the Fed’s announcement, the price of long-term Treasury securities increased and the 10-year Treasury yield fell to a record low.4 Stocks, however, did not react favorably.

Here’s a look at how the Fed’s policy decisions could affect the U.S. economy and financial markets, and some possible implications of a longer-term, low-interest-rate environment for investors, savers, and retirees.

Powerful Words

The federal funds target rate, which is the central bank’s primary means of manipulating short-term interest rates, has been kept near zero since 2008. Signalling that interest rates would remain low for at least two more years was probably intended to help hold down longer-term rates, which could prompt households and businesses to increase spending and investment.5

For example, low interest rates on cash alternatives could spark businesses and investors to find more productive uses for their money. Lower borrowing costs might make large investments in factories, heavy equipment, and other expansion projects more affordable. The same incentive may apply to consumers, some of whom could benefit from lower borrowing costs for major purchases.
Voices of Dissent

Setting a specific, longer-term timeline for maintaining low rates was unprecedented. In fact, three committee members disagreed with both the August and September statements, suggesting some dissent.6

Critics believe the Fed’s action could actually provide an incentive for households to wait to borrow or spend if they are counting on rates to remain low for a long time. Cautious consumers seem reluctant to spend and are more concerned with paying down debt and strengthening their own financial positions.7

A weak housing market indicates that few people have been willing or able to take advantage of already low mortgage rates. Tight lending standards often make it more difficult for potential buyers to qualify for financing.8

Another concern is that long periods of loose monetary policy and low interest rates could weaken the dollar and lead to higher inflation.

An Expected Twist

Prior to the September meeting, there was already an expectation that the central bank would try “Operation Twist” in an attempt to flatten the yield curve, lower long-term interest rates, and stimulate the economy.9

There is often a great amount of speculation on the part of businesses, investors, and the media prior to any official FOMC announcement. To some degree, the odds of an expected action may already be “priced into” the financial markets before any decisions are made. Surprises, however, tend to have a more dramatic effect on stock and bond prices.
Prolonged Suffering for Savers

The prospect of low interest rates for several more years could continue to make it difficult for retirees and others who rely on fixed-income investments. Returns on interest-bearing accounts and other guaranteed or lower-risk investment vehicles are unlikely to keep pace with inflation, and some investors may decide to assume more risk in pursuit of higher yields.

The central bank’s assertion that interest rates would remain low for two more years was based on its economic forecast and is not necessarily a firm promise. The Fed could tighten its policy stance if inflation rises or there is a noticeable improvement in economic conditions.

All investments are subject to market fluctuation, risk, and loss of principal. When sold, investments may be worth more or less than their original cost. U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest. The performance of an unmanaged index is not indicative of the performance of any specific security. Individuals cannot invest directly in an index.

1) CNNMoney, August 9, 2011
2) The Wall Street Journal, August 10, 2011
3) Federal Reserve, 2011
4) CNNMoney, September 21, 2011
5) Los Angeles Times, August 10, 2011
6) The Washington Post, August 9, 2011
7–8) The New York Times, August 14, 2011
9) Reuters, September 7, 2011

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2011 Emerald Connect, Inc.