The Fed surprises everyone

The Federal Reserve Board surprised everyone Wednesday by saying it would actually continue its unprecedented stimulus efforts despite the expectations of everyone. And investors cheered the news, sending the stock market to record highs.

The New York Times had this story, excerpted below:

All summer, Federal Reserve officials said flattering things about the economy’s performance: how strong it looked, how well it was recovering, how eager they were to step back and watch it walk on its own.

But, in a reversal that stunned economists and investors on Wall Street, the Fed said on Wednesday that it would postpone any retreat from its monetary stimulus campaign for at least another month and quite possibly until next year. The Fed’s chairman, Ben S. Bernanke, emphasized that economic conditions were improving. But he said that the Fed still feared a turn for the worse.

And the Fed undermined its own efforts when it declared in June that it intended to begin a retreat by the end of the year, causing investors to immediately begin to demand higher interest rates on mortgage loans and other financial products, a trend that the Fed said Wednesday was threatening to slow the economy.

Investors cheered the Fed’s hesitation. The Standard & Poor’s 500 stock-index rose 1.22 percent, to close at a record high, in nominal terms. Interest rates also fell; the yield on the benchmark 10-year Treasury reversed some of its recent rise.

Some analysts, however, warned that the unexpected announcement was likely to worsen confusion about the Fed’s plans, increasing the volatility of the markets in the coming months as investors sort through the Fed’s mixed messages about how much longer it plans to continue its bond-buying campaign. The delay also means that the decision to retreat may ultimately be made by the next Fed chairman, after Mr. Bernanke steps down at the end of January. President Obama has said that he plans to nominate a replacement as soon as next week. Janet L. Yellen, the Fed’s vice chairman, is the leading candidate.

The Wall Street Journal story added this context about the program and how long it’s been in place:

The bond-buying program, also known as quantitative easing, or QE, was relaunched last year and is meant to stimulate economic growth and hiring by holding down interest rates and encouraging households and businesses to spend and invest. This round of purchases, together with earlier efforts along the same lines, has swelled the Fed’s holdings of securities to nearly $4 trillion.

Mr. Bernanke began signaling in May that, because the job market was gradually improving and because the Fed anticipated faster growth by year-end, the central bank might pull back on the bond-buying program.

After two days of deliberations, however, Fed officials decided Wednesday the economy hadn’t lived up to their expectations for growth. In fact, they lowered their growth estimates for this year and next—and expressed worry that a jump in long-term interest rates over the past several months could squeeze an already weak upturn.

The Financial Times added the details of the purchasing programs and said that interest rates will likely stay low for years to come:

The Fed will continue to purchase mortgage-backed securities at a pace of $40bn a month and Treasury securities at a pace of $45bn a month. It made no change to its 6.5 per cent unemployment rate threshold for a rise in interest rates. The vote for the decision was 9-1 in favour.

One factor may have been a downgrade to the FOMC’s growth forecasts for this year and next. The Fed now expects growth of 2.2 per cent in 2013 compared with a June forecast of 2.5 per cent; and 2014 growth of 3 per cent compared with a June forecast of 3.3 per cent.

In a strong signal that the Fed intends to keep rates low for a long time into the economic recovery, the FOMC estimated that interest rates would be 1 per cent at the end of 2015 and 2 per cent at the end of 2016.

The interest rate forecast for 2016 is low even though the Fed expects the economy to be close to full employment by then. It predicted an unemployment rate of 5.7 per cent at the end of 2016 compared with a long-run equilibrium of 5.5 per cent.

The markets obviously liked the news, and I’m sure real estate agents and mortgage brokers were thrilled with the thought of low interest rates for the foreseeable future. It’s interesting that Bernanke is potentially punting the decision to the next Federal Reserve head. All eyes are now on Obama to make a choice.