Fed keeps low rates as recovery idles

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Hemmed in by a moribund economy and rising unemployment, the Federal Reserve’s Open Market Committee, or FOMC, reaffirmed its commitment to near-zero interest rates Wednesday, but also signaled that there won’t immediately be a “QE3” program to succeed its “QE2” effort to induce bank lending.

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The Fed’s actions are bad news for savers, who have struggled with pitifully low returns on certificates of deposit and money market accounts for years now. But they are good news for borrowers — at least those lucky enough to get a loan — by keeping consumers’ products, such as mortgages, at rates near record lows.

In making its announcement, the Fed acknowledged its frustrations in dealing with an economic recovery that seems to have lost momentum since the FOMC last convened in April.

In its statement, the FOMC said “the economic recovery is continuing at a moderate pace, though somewhat more slowly than the committee had expected. Also, recent labor market indicators have been weaker than anticipated.”

“The unemployment rate remains elevated; however, the committee expects the pace of recovery to pick up over coming quarters and the unemployment rate to resume its gradual decline … “

Economists said the low rates championed by Fed Chairman Ben Bernanke indeed point to lingering malaise more than two years after the recovery from the Great Recession officially began.

“The Fed is just baffled as to why the economy has been much slower than expected,” says Axel Merk, president of Merk Investments in Palo Alto, Calif.

Beyond the Fed’s control

Nevertheless, events beyond the FOMC’s control, such as the Congressional gridlock over raising the federal debt ceiling, and the eurozone fiscal crisis, could yet force up interest rates despite what the Fed wishes, says Mark Thoma, professor of economics at the University of Oregon. Fears about the U.S. federal deficit have also rattled global financial markets in recent months.

“Uncertainty over the debt ceiling could cause investors to start demanding risk premiums, which could send interest rates up generally,” says Thoma. He adds: “If interest rates are going up because of lack of safety, that’s not really what they are looking for, either.”

J. Antonio Villamil, dean of the business school at St. Thomas University in Miami Gardens, Fla., said the Fed’s efforts to date have propped up the economy and kept the banking system flush with cash. However, there’s little evidence that the money is being lent at a pace that would stimulate job creation and thus whittle the stubbornly high 9.1 percent unemployment rate.

Consumer impact

“The impact on the real economy, spending on goods and services, has been very small,” says Villamil, who served as undersecretary of commerce in the George H.W. Bush administration. “If I were grading the Fed, I’d have to give them an incomplete.”

Similarly, with banks and home prices still not recovered from the housing meltdown, the record-low mortgage rates have been little help to the economy. Consumers “are looking at deflationary expectations,” giving them an incentive to wait, Villamil says. As for banks: “It takes a lot of time to fix balance sheets. I don’t know what else (the Fed) can do.”

Although the Fed doesn’t officially set rates on consumer loans, it holds enormous sway by setting targets for the so-called federal funds rate. The federal funds rate is what banks charge on short-term loans to one another. As such, it acts as a baseline for loan pricing.

The current targeted rate for federal funds, in effect since 2008, is zero percent to 0.25 percent. It’s likely to stay there for the foreseeable future, says Bill Hampel, chief economist for the Credit Union National Association.

“Until the unemployment rate gets within striking, or even shouting, distance of 8 percent, it’s really unlikely that the Fed is going to do anything to raise short-term interest rates,” says Hampel.

Beyond ‘QE2’?

The rock-bottom borrowing costs mean the Fed’s traditional way of stimulating the economy — cutting rates to induce borrowing — is not an option. In response, Bernanke undertook a program known as quantitative easing. Despite its complicated name, quantitative easing is simply an effort to pump money into banks. The Fed does this by purchasing Treasury securities from banks, which are left with the funds.

The thinking was that, flush with low-cost cash, banks would start lending and job creation would follow. When the first round of quantitative easing didn’t produce the desired results, the Fed launched the “QE2” program in late 2010. It, too, has received mixed reviews.

“With ‘QE1’ and ‘QE2,’ I thought it was great for equity markets,” says Stephen Morrell, an economist at Barry University in Miami Shores, Fla. “What it didn’t help a bit was the bank lending side.”

“QE2” is now expiring, but experts don’t expect a “QE3” just yet. The Fed will continue to reinvest the proceeds of maturing Treasuries, however. That should maintain downward pressure on rates.

“‘QE2’ will expire in June, but they still are buying bonds with the revenues of the bonds that are coming to maturity,” says Adolfo Laurenti, deputy chief economist at Mesirow Financial in Chicago. “The economy is not gaining any momentum, and they don’t want to send the message to the market that tightening rates will come sooner rather than later.”

The Fed indicated that conditions won’t change in the near term. “The committee continues to anticipate that economic conditions … are likely to warrant exceptionally low levels for the federal funds rate for an extended period.”

The FOMC next meets Aug. 9.