Its Forecast Dim, Fed Vows to Keep Rates Near Zero

The Federal Reserve made a rare promise on Tuesday to hold short-term interest rates near zero through at least the middle of 2013, in a sign that it has all but written off the chances of an expansion strong enough to drive up wages and prices.

It is now conventional wisdom among forecasters that the economy will plod along through the end of President Obama’s first term in office. Millions of Americans will not find work. Wages will not rise substantially.

By its action, the Fed is declaring that it, too, sees little prospect of rapid growth and little risk of inflation. Its hope is that the showman’s gesture will spur investment and risk-taking by convincing markets that the cost of borrowing will not rise for at least two years.

The Fed’s statement, with its mix of grim tidings and welcome aid, contributed to wild market oscillations as investors struggled to make sense of the economy and the path ahead. The day ended in a huge upward surge on the New York Stock Exchange — the second busiest day this year after the record volume on Monday, during a deep sell-off — that could not be tallied completely until well after the markets had closed.

The Dow swung as much as 600 points in the wake of the Fed statement, at first sinking over 200 points. But after traders absorbed the decision, they quickly reversed course, and the Dow closed the day up 429 points, or 4 percent, to 11,239.77, as some investors expressed hope that the pledge to keep interest rates low could relieve some of the gloom over the economic outlook.

“The economy is in tough shape and the Fed had a difficult job of showing that they understood that without appearing to be alarmist,” said Steven Lear, who helps to manage a $150 billion fixed-income portfolio for J.P. Morgan Asset Management. “We think that they’ve played that hand about as well as they could.”

The policy announced Tuesday is an incremental step that economists described as unlikely to drive significant growth. The Fed already has held rates near zero since December 2008, and the economy is awash in cheap money. The great impediment, beyond the Fed’s easy reach, is the lack of demand from indebted consumers, nervous businesses and a shrinking public sector.

The Fed demurred, however, from taking stronger steps to aid the struggling economy, a decision that reflected deepening divisions on its policy-making committee, which generally tries to move only by unanimous consent. The vote to promise two more years of low rates passed by a margin of 7 to 3, the first time in almost 20 years that at least three members recorded votes in dissent.

The internal controversy parallels the broader debate in Washington between those pleading for the government to redouble its support for the faltering economy, and those who doubt the utility of additional aid and fear the consequences of the vast efforts already made. The three Fed members in dissent all have expressed concern that the central bank is not paying enough attention to inflation.

The Fed said in a statement that it would continue to consider additional measures to support the economy, but the split vote suggested that the Fed’s chairman, Ben S. Bernanke, may struggle to win sufficient support.

The statement, which includes an assessment of the economy, was a patchwork quilt of discouraging language. The labor market is deteriorating, construction is weak, housing depressed, recovery slow.

“Economic growth so far this year has been considerably slower than the committee had expected,” it said. “The committee now expects a somewhat slower pace of recovery over coming quarters.”

Twenty-five million Americans cannot find full-time work, a number the Fed said would decline “only gradually.”

The Fed is charged by Congress with minimizing unemployment, and increasingly vocal critics have questioned why the central bank is standing still even as the economy shows clear signs of faltering. The modest step announced Tuesday did not satisfy many of those critics.
“The Fed took the least action possible given the circumstances,” Sherry Cooper, chief economist at the BMO Financial Group, said in a note to clients. “Bottom Line: Holy Cow!”
In part, the Fed’s answer is that it is already engaged in an immense program of economic aid.

The central bank has held its benchmark short-term interest rate near zero for more than two years, flooding the financial system with the nearest thing to free money. It already had promised, most recently in June, that it would keep rates near zero “for an extended period” — at least several months, Mr. Bernanke said earlier this year.

The Fed also has amassed a portfolio of more than $2.5 trillion in Treasury securities and mortgage-backed securities, putting downward pressure on long-term interest rates. The purchases have pushed investors into the stock market and other riskier investments, and reduced the value of the dollar, helping American exporters.

The decision announced Tuesday is intended to put additional pressure on long-term interest rates, although not with the same direct force as buying $600 billion in securities, a program it completed in June. The rates on long-term securities reflect a combination of expectations about short-term rates and a risk premium for holding a long-term note. Buying bonds reduces that risk premium; by promising to keep rates low, the Fed aims to reduce expectations about future short-term rates.

The Fed’s statement stopped short of an absolute commitment to provide two years of near-zero rates, preserving some room for movement if economic conditions change drastically. But Vincent R. Reinhart, who headed the Fed’s monetary affairs division until 2007, said the meaning was clear.

“It’s as close to an unconditional commitment as you can get out of a central banker,” said Mr. Reinhart, now a scholar at the American Enterprise Institute. “It means that you’ve handcuffed yourself. You can’t change it. You’ve given up unless there’s an overwhelming case to offset inflation risk.”

A second reason for the Fed’s restraint, it is increasingly clear, is the opposition of a group of Fed officials who are concerned that the central bank is overly discounting the risk of inflation.

The three members who dissented from the majority Tuesday were Richard W. Fisher, president of the Federal Reserve Bank of Dallas; Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis; and Charles I. Plosser, president of the Federal Reserve Bank of Philadelphia.

By law the Fed is responsible for keeping prices steady and unemployment as low as possible. But Mr. Bernanke, like his predecessors, places greater emphasis on prices, in part because the Fed has concluded that slow, steady inflation — about 2 percent a year — is the best atmosphere for enduring job growth.

The Fed projected in June that inflation could reach 2.5 percent this year, a crucial reason for its announcement then that it would pause before considering new measures.

There are now signs that inflation is abating, as a temporary spike in commodity prices earlier this year works through the economy, and as growth weakens. Mr. Bernanke and his allies on the committee have predicted as much all year, and the announcement on Tuesday reflects confidence in that judgment.

But conservative members of the policy-making board see evidence in past recoveries that inflation can accelerate quickly, with little warning. Their dissents echo the last time the committee was as deeply divided, in November 1992, when three members pressed to begin raising the short-term interest rate, which then stood at 3 percent.

The Fed’s statement, indicating that it will continue to consider additional options despite those internal divisions, sets the stage for Mr. Bernanke’s speech later this month at a conference in Jackson Hole, Wyo. Last year, he used the opportunity to indicate that the Fed would undertake a new round of asset purchases. “The markets,” Mr. Lear said, “will be actively interested to hear what he says.”