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.

Financial World Relies on Key Groups to Track the Economy

Over the years, the closely watched “yield curve” has been fairly adept at signaling the onset of U.S. economic recessions. When short-term Treasury yields exceed long-term yields, an economic slowdown often results. When such a yield “inversion” occurred in late 2005, some economists pointed to it as an indication that a recession was approaching. Some two years later, the economy indeed fell into recession.

A yield curve inversion would seem to be a fairly straightforward method for ascertaining the direction of the economy, but more often than not, matters are not so simple. This is evidenced by the committees and teams who join forces to study the economy and weigh in with predictions and forecasts. Here’s a look at some of the key organizations that bring together the world’s most powerful and influential economists.

Beyond the Curve

Image via Wikipedia

The Federal Reserve’s Federal Open Market Committee is ground zero for information about the possible future of interest rates. The committee is composed of the seven members of the Federal Reserve Board and five of the 12 Federal Reserve Bank presidents. They meet nine times a year to set monetary policy. Even though the FOMC announces its decisions immediately after each meeting, the announcements are couched in sterile language that does little to indicate what really happens during the meetings. It’s a bit like hearing the score of a football game without seeing any of the action — the score reveals the outcome but not the drama. The real action can be seen in the meeting minutes, which are usually released a few weeks later. Analysts and journalists pore over the minutes for clues about whether the committee was divided, what specific concerns were discussed, and what data motivated the committee’s decision.

The Wall Street Journal’s Economic Forecasting Survey also showcases competing views. This monthly poll of more than 50 economists reveals predictions of major economic indicators, such as inflation, interest rates, taxes, and employment. Their consensus forecasts are published in the newspaper each month, but their individual views are sometimes more interesting. To adapt an old saying, 50 heads are better than one, and considering the differences among the surveyed economists can sometimes provide clues about how they reached their consensus views.

The National Bureau of Economic Research’s Business Cycle Dating Committee has the last word on when recessions start and end, even though their judgments sometimes come years after the fact. This cautious group of academics uses a broad measure to define a recession: not simply two quarters of declining gross domestic product but also weakness in income, employment, production, and sales. Although the business cycle committee gets most of the headlines, the NBER itself might be the most prestigious collection of economists in the world or in history. Many of its members are Nobel Prize winners; several have served as economic advisers to the president of the United States or as governors and chairmen of the Federal Reserve.

Everyone has an opinion, but clearly not all opinions are equal. Considering the views offered by the best of the best may help with decisions about your Naperville Investments portfolio.

1) The Wall Street Journal, August 16, 2010

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.

Related articles

• Double-Dip Recession? The Yield Curve Says No (dailyfinance.com)
• TREASURIES-U.S. yield curve flattens a bit before supply (reuters.com)

Madoff victims may get millions in tax refunds

Madoff victims may get millions in tax refunds
Lita Epstein

Aug 6th 2009 at 2:00PM

Taking advantage of a special IRS rule for Ponzi-scheme losses, some Madoff victims are starting to get some of their money back in the form of IRS refunds, according to a report in today's Wall Street Journal. So far the biggest refund is about $500,000 dollars, but some people have filed returns for multi-million dollar refunds. In March the IRS ruled that investors could take a theft loss on their amended 2008 returns. Since many Madoff investors let their money grow with Madoff for 20 years or more and paid taxes on the dividends and capital gains they supposedly earned, even though they didn't take the money out, they are sitting on multi-million dollar loses.

The IRS is paying out less to those who are suing third parties, on the assumption that they have a better prospect of recovering losses. Some tax accountants advised their clients to wait on filing because they didn't know how the IRS would handle the refunds. So their clients will need to file for refunds on their 2009 returns. I'll bet the people that were advised to hold off wish they had filed those amended claims. Who knows how generous the IRS will be next year?Those that did file amended 2008 tax returns will soon have cash in their pocket. Sometimes not playing games does pay off with the IRS.

Lita Epstein has written 25 books including The Complete Idiot's Guide to Tax Breaks and Deductions.