Fed tries again to revive economy

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No changes to monetary policy or interest rates came out of this week’s meeting of the Federal Reserve’s rate-setting committee.

With monetary policy standing still, it’s business as usual in the new normal. That means exceedingly low borrowing costs for consumers who can swing it — and painfully low interest rates on savings and fixed-income investments.

The federal funds rate will remain at its current level near zero percent, and the extension of Operation Twist will continue. Operation Twist is the nickname for the Fed’s attempt to keep a lid on long-term interest rates by swapping securities in its portfolio.

Though the Fed announced no new stimulus programs, its statement, released after the meeting, indicated that the door remains wide open for more quantitative easing should the need arise. Quantitative easing injects money into the financial system through securities purchases, thus increasing the money supply. In theory, it should lower the cost of borrowing and give banks more money to lend.

What does that mean for me?

The Federal Open Market Committee sets the benchmark rates for many consumer loans and savings vehicles by way of the federal funds rate, the interest rate banks charge each other for overnight loans. The federal funds rate has been near zero percent since December 2008.

The prime rate is directly tied to the federal funds rate, and it stands at 3.25 percent. Rates on variable-rate credit cards and home equity lines of credit move with the prime rate. Savings vehicles such as CDs are also directly influenced by movements in the federal funds rate.

Mortgages, auto loans and debt investments such as bonds are indirectly influenced by the Fed’s rate machinations.

Quantitative easing and Operation Twist have kept interest rates low as many mortgages, auto loans and bond rates are linked loosely to Treasury yields.

When Treasuries are in high demand, as when a high roller such as the Fed enters the market and starts throwing around billions, bond prices go up, and yields go down. Lower Treasury yields can translate to lower loan rates.

Growth is expected — but so is turbulence

While hopes for reasonable economic growth this year are still high, the FOMC did recognize that shocks from Europe could send the economy off the rails.

“The Committee expects economic growth to remain moderate over coming quarters and then to pick up very gradually,” the statement said. “Consequently, the Committee anticipates that the unemployment rate will decline only slowly toward levels that it judges to be consistent with its dual mandate. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook.”

The Fed’s statement acknowledged that the economy has slowed down, but there is still some continued growth in output, says Gary Thayer, chief macro strategist for Wells Fargo Advisory Services.

Despite rumors that the central bank may be gearing up for more easing action in the future, today’s meeting shows it in standby mode.

“Obviously, the economy is stuck, and they recognize it, but they might be placing a little bit more emphasis on inflation expectations down the road. With rates at zero percent, there may be more spending in some areas,” says Surendra K. Kaushik, professor of finance at Pace University’s Lubin School of Business in New York.

“There are shortages developing, in the agriculture sector, for example, because of the drought … and industrial growth is not really strong, so there is too much money and not enough goods, so we could have a potentially demand-pull type of inflation, the old-fashioned kind,” he says.

Demand-pull inflation is when prices increase as a result of demand outstripping supply.

Quantitative easing: A question of when, not if, for some

Though the Fed pledged to continue Operation Twist through the end of the year, some analysts expect more direct action later this year, this time more focused on mortgage-backed securities rather than hewing only to Treasuries.

“I’m expecting something in either September or October. I think they want to do something in coordination with the other central banks around the world, and they want to wait until after the economic summit in Jackson Hole (Wyo.), before they do anything,” says Sharon Stark, chief market strategist at Sterne Agee, a privately owned brokerage firm in Birmingham, Ala.

Then again, Operation Twist has had some success in addressing housing market woes, at least in keeping mortgage rates at record lows.

“By pushing long-term rates down, it is helping the housing market with increased refinancing and some signs of life in sales. But the past two QE movements have almost raised interest rates as inflation expectations picked up,” Thayer says.

Housing and employment still lag

Economic growth has slowed from the beginning of the year. The economy grew at an annual rate of 1.5 percent in the second quarter, down from 2 percent earlier in the year, according to the most recent report from the Commerce Department.

Also troubling for the FOMC is the persistent unemployment, currently lodged at 8.2 percent. The housing sector as well remains an albatross, though it has shown signs of a turnaround.

“Housing is improving, but every month, you get mixed reports — good and bad reports. Low housing starts, or new homes sales drop. All those mixed signals, but the market is still pretty bad in housing,” says Kaushik.

In June, housing starts showed glimmers of hope, up to 760,000 in June from an annual rate of 711,000 in May. The June report reflects a 24 percent increase over 2011, according to High Frequency Economics.

Conversely, existing home sales fell 5.4 percent from May to June this year, the National Association of Realtors reported.

In 2010, the chairman of the Federal Reserve, Ben Bernanke, revealed plans for a second round of quantitative easing in a speech at the Jackson Hole economic symposium hosted by the Kansas City Federal Reserve Bank held annually in late August. Fed watchers predict the possibility of history repeating itself this year but, as with many other economic topics lately, it’s too soon to guess what will happen.

As the Fed wished, Treasury yields have fallen during Operation Twist. Since the beginning of 2012, the 10-year Treasury yield has slipped from 1.97 percent to 1.53 percent. The 30-year yield is down from 2.98 percent to 2.58 percent. Lower Treasury yields are partly a result of Fed actions and partly from the flight to safety as investors sought havens from global volatility.

In June, the rate-setting Federal Open Market Committee announced that it would extend Operation Twist through the end of the year, exchanging another $267 billion in short-term investments for longer-term securities.