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Larry Downing / Reuters
Fed Chairman Ben Bernanke has been a dominant force in pushing for more openness at the central bank.
New normal, meet the new Fed.
The Federal Reserve took two major new steps Wednesday to assure businesses and consumers that it intends to keep borrowing costs at record low levels for the foreseeable future – at least three years.
For the first time in its 94-year history, the central bank opened its mind to the public, publishing a collection of charts that break down policymakers’ forecasts on interest rates, inflation and unemployment. And for the first time ever, it set an explicit target for inflation, 2 percent a year, instead of an implied target.
Both steps are in keeping with Fed Chairman Ben Bernanke’s stated goal of making the Fed’s decisions ever more transparent. Economists welcomed the new moves but said they have their own risks.
The first headline to come out after central bankers ended their two-day meeting Wednesday was the news that policymakers do not expect to raise short-term interest rates until late 2014 at the earliest, rather than mid-2013 as they said a month ago. Those record-low rates are still needed to help boost an improving but still sluggish economy, the Fed said in the new statement.
"I think what they are seeing is that the rate of growth is not sufficient to bring down the unemployment rate,” said Brian Dolan, chief strategist at Forex.com. Unemployment stood at 8.5 percent at the latest reading in December, with 13 million Americans who would like a job unable to find one.
The latest data show the economy beginning to strengthen: Hiring has picked up, factories are increasing output and car sales are rising. Still, the threat of a recession in Europe continues to weigh on the global economy. U.S. consumers have been resorting to borrowing again to maintain spending levels that may not be sustainable.
In its latest forecast, the central bank cut its growth outlook this year but is now a bit more optimistic about the unemployment rate. It expects the U.S. economy to grow between 2.2 percent and 2.7 percent this year. That's down from its November's forecast of between 2.5 percent and 2.9 percent. But it sees unemployment falling as low as 8.2 percent this year, better than its earlier forecast of 8.5 percent. December's rate was 8.5 percent.
By making its plans and expectations clear and explicit, the Fed is hoping to boost public confidence that interest rates will stay low. If the strategy works, that higher confidence will encourage investment and spending that would give the moribund economy a lift.
The plan could create problems for Fed officials down the road as economic conditions change. Though the disclosures are being billed as “expectations,” investors have come to view the pronouncements as commitments. If events overtake the Fed’s current thinking, those expectations may have to be altered. That could undermine the credibility of these forecasts, according to Credit Suisse economists.
“Eventually, the Fed is bound to discover it cannot live up to the policy trajectory communicated to the market,” they wrote in a recent note explaining the changes in Fed’s communication strategy. “When this happens the Fed will have enhanced its transparency at the expense of its credibility. And between those two assets, credibility is by far the more important.”
That, the economists argue, could have ”the perverse effect of encouraging greater volatility in the fixed income markets, especially when the FOMC eventually starts forecasting higher funds rate targets.”
Promising to keeping rates low to spur borrowing and spending may be a double-edged sword. Potential home buyers, for example, may be happy to sit on the fence as long as they don’t have to worry about missing out on record-low mortgage rates.
“It may take the floor away from the housing market,” said Douglas C. Borthwick, managing director at Faros Trading. “With no apparent need for buyers to lock in lower rates today they may be more encouraged to wait a little while longer to pull the trigger. Why buy today when there may be more supply tomorrow?"
Since the Great Recession of 2007-09 and the biggest housing collapse since the 1930s, the Fed has thrown pretty much everything in its toolkit at the financial system, trying to revive the economy. Conventional moves targeting short-term lending have been followed by unorthodox schemes that included massive buying of mortgage bonds and a switch in the maturities of Treasury bonds to drive down longer-term rates. On Wednesday, the Fed announced no new plans to buy bonds.
Economists generally believe the Fed’s initial moves succeeded in heading off a deeper financial and economic collapse. But the economy is still growing slowly, and the job and housing markets are still badly broken.
The Fed has been debating for some time the idea of publishing its internal inflation and unemployment forecasts. The central bankers have been following an unofficial inflation target of about 2 percent of the last few years.
Part of the problem with publishing both inflation and unemployment targets is that, while they are both part of the Fed’s “dual mandate,” managing the two objectives often call for conflicting policies. Controlling inflation often calls for tighter monetary policy, for example, which typically slows growth and raises the level of unemployment.
The Fed’s new rate-forecast policy may already be having the desired impact. As details of the Fed’s new policy have been disclosed, interest rates on U.S. Treasury bonds, a bellwether for borrowing costs from mortgages to corporate commercial paper, have been edging lower.
On Wednesday, Treasury yields fell on the news that the Fed plans no rate increase until late 2014 at the earliest. The yield on the 10-year note sank to 1.95 percent, down from 2.02 percent just before the Fed made its announcement.
Lower yields could help further reduce mortgage rates and possibly boost stock prices as investors shift out of lower-yielding Treasurys. Stocks, which had traded lower before the Fed announcment, quickly recovered their losses. The Dow Jones industrial average, which had been down about 60 points before the announcement, was up 81 points shortly before the close.
Related:
Fed Chairman Ben Bernanke says he will "not get involved in political rhetoric" and also shares insight on Dodd-Frank.
This is welcome news, assuming that political machinations don't overturn these plans.