mortgage

The Fed stays its controversial course

Federal Reserve building
Highlights
  • Fed continues policy of low short-term rates, hurting savers.
  • Fed continues policies designed to drive long-term rates lower.
  • Critics contend Fed policies haven't helped economy.

Some observers have proclaimed the Federal Reserve's newest economy-goosing gambit a success, and others have condemned it as a failure. Today, the Fed sidestepped that argument, announcing that the controversial monetary policy will continue.

The Fed will keep buying long-term Treasury notes from banks to promote a stronger economic recovery, the central bank said today at the end of its scheduled monetary policy meeting. And, as expected, the Fed's rate-setting Open Market Committee will keep a key short-term interest rate near zero. That means that the prime rate will remain 3.25 percent, and rates on home equity lines of credit and variable-rate credit cards won't change.

Rates on short-term certificates of deposit will stay very low. The low rates reward borrowers and punish savers, a combination designed to encourage people and businesses to spend.

Banks make overnight loans to one another at the federal funds rate. In turn, the prime rate and other lending rates are based on it. The Fed boosts short-term rates to cool off the economy, and cuts short-term rates to heat it up.

The Federal Open Market Committee's job is to boost employment and keep prices stable. In normal times, the panel tackles this task by raising or lowering its target for the federal funds rate. But these aren't normal times, and the Fed has experimented with manipulating long-term bond yields and interest rates, too. It's hard to know whether the latest experiment has succeeded or failed -- or if it's too early to tell.

But the Fed's strategy on short-term rates hasn't been enough to pull the economy out of the ditch. The federal funds rate has been in a range of between zero percent and 0.25 percent for two years now. When the Fed took the unprecedented step of pushing the overnight rate that low Dec. 16, 2008, the unemployment rate was 7.2 percent. Last month it was 9.8 percent.

Strategies for long-term rates have also produced mixed results. Faced with stubborn joblessness, the Fed tried twice to push down long-term interest rates in a move observers dubbed quantitative easing. In the first round of quantitative easing, the Fed pumped $1.7 trillion into banks by buying Treasury debt and mortgage-backed securities. As intended, long-term interest rates fell.

That bout of quantitative easing ended March 31. Throughout March, economists and lenders warned that mortgage rates would begin rising April 1 and would rise through the year's end. Instead, rates fell. Mortgage rates dropped to levels that hadn't been seen since before Elvis had a record deal. Yet, unemployment kept rising, and inflation was so low that consumers had little incentive to rush any purchases. So on Nov. 3, the Fed announced a second round of quantitative easing, or QE2. The Fed will buy at least $600 billion in Treasuries through June.

Two days after the Fed announced QE2, Chairman Ben Bernanke explained in an opinion piece in The Washington Post that "(e)asier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance."

Instead, mortgage rates have risen half a percentage point since the announcement of QE2. Fewer homeowners can refinance. "We have fallen into the liquidity trap where further rate cuts will achieve nothing other than signal panic by the Fed," says Anthony Sanders, professor of finance at George Mason University.

Before you judge QE2 a failure, keep in mind that the Fed also wants to raise the inflation rate so consumers will buy now, instead of keeping money in their pockets. Rising rates can be interpreted as an expectation that prices will rise -- in other words, that the Fed is succeeding. Jeremy Siegel, professor of finance at the University of Pennsylvania's Wharton School, made this argument in an opinion piece in Tuesday's Wall Street Journal. "The Fed's QE2 program has raised expectations of growth and inflation, sending long-term Treasury rates up," Siegel writes.

Siegel's colleague at Wharton, finance lecturer Kenneth Thomas, says it's too early to judge the success or failure of QE2. "People say 'don't fight the Fed,' but sometimes there are forces out there that, even though the Fed is going one way, things don't always work out the way you expect," Thomas says.

In the weeks since QE2 was announced, the president and Congressional Republicans have agreed on a tax plan that will swell the budget deficit and stimulate the economy. Meanwhile, bond holders have fresh reason to worry that some European countries could default on their debts. The combination of inflationary tax policy and increased risk premiums on national debts has resulted in higher bond yields and interest rates everywhere, Thomas says.

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