Fed May Need To Find New Tricks Up Its Sleeve

Federal Reserve Chairman Ben Bernanke told Congress in July that the Fed was ready to act if the economy weakened. On Tuesday, the Fed announced it was prepared to keep interest rates low until at least mid-2013. i i

Federal Reserve Chairman Ben Bernanke told Congress in July that the Fed was ready to act if the economy weakened. On Tuesday, the Fed announced it was prepared to keep interest rates low until at least mid-2013. Susan Walsh/AP hide caption

itoggle caption Susan Walsh/AP
Federal Reserve Chairman Ben Bernanke told Congress in July that the Fed was ready to act if the economy weakened. On Tuesday, the Fed announced it was prepared to keep interest rates low until at least mid-2013.

Federal Reserve Chairman Ben Bernanke told Congress in July that the Fed was ready to act if the economy weakened. On Tuesday, the Fed announced it was prepared to keep interest rates low until at least mid-2013.

Susan Walsh/AP

The Federal Reserve has issued one of its gloomiest pronouncements about the economy in a long time: It says it sees little prospect that growth will rebound much anytime soon, and that it's ready to keep interest rates low for the next two years.

The recent downturn leaves Fed officials without any of its obvious ways of fixing the economy, and analysts say it may need to try steps it hasn't taken before.

Joe Gagnon spent part of his career as a Fed economist, and Tuesday he saw something he thought he'd never see at the central bank.

"I was flabbergasted, actually, I kept thinking it was a typographical error," he says.

Gagnon, who is now with the Peterson Institute for International Economics, says the Fed typically likes to send signals about how long it will keep interest rates at a certain level, but usually the signals are vague.

"They really don't want to have their hands tied because of the unknown that the future might bring," he says. "They're worried that the market won't read it correctly or they might somehow be trapped into doing something they don't want to do in the future."

An Unprecedented Measure

Tuesday, however, the Fed said it would keep interest rates low until at least mid-2013. That might not seem like such a big deal, but to people who follow the Fed it was unprecedented.

The Impact Of Low Rates

The Federal Reserve's announcement that it expects to keep interest rates at "exceptionally low levels" for at least the next two years could have wide-ranging impacts on consumers and businesses. The Fed has kept its rate target at historic lows — near zero — since the end of 2008 in response to a persistently weak economy and turmoil in the financial system.

At the same time, rates on U.S. Treasury securities have tumbled since Friday's Standard and Poor's downgrade of U.S. debt. The Treasury sold 10-year notes at a record low 2.14 percent Wednesday. Investors have fled into Treasurys as a safe haven, which has had the effect of lowering rates as well.

Here's who low rates can help:

Homeowners: Mortgage rates have been falling — rates on 15-year mortgages hit a record low of 3.54 percent and 30-year fixed loan rates fell to an average 4.39 percent last week, according to Freddie Mac. That means it's cheaper to borrow to buy a home or to refinance an existing mortgage. But even with low rates, the housing market remains "depressed," the Fed said Tuesday.

Consumers: Credit card rates are generally linked to the prime rate, which in turn is tied to the federal funds rate — the rate the Fed has pledged to keep low. For now, with the economy slowing, credit card rates are unlikely to rise. But that could change if the S&P downgrade eventually drives up U.S. borrowing costs.

Car Dealers: Auto sales could get a lift if rates for car loans remain low. But if the economy stays weak and people continue to worry about keeping their jobs, they may be reluctant to spend on big-ticket items.

Companies: Businesses may find the Fed's two-year timeline for keeping rates low helpful in planning expansions. And lower borrowing costs can mean higher profits.

Farmers: Like businesses, farmers rely on credit to operate. Farmers borrow to buy equipment, seed and fertilizer. Low rates should lower their costs and boost profits.

Here's who may be hurt by low rates:

Savers: Rates on bank savings accounts are already well below 1 percent in most cases, which means a negative return after adjusting for inflation. But many people are willing to stay in federally insured savings rather than putting their money in stocks or other investment that carry more risk.

"To actually put a number, a date, is actually first," says Alan Blinder, a former Fed board member. He says the Fed probably did it out of desperation. "I think the Fed is looking, as all of us are, at a weakening economy and it is out of its conventional weaponry."

By sending such an explicit message about interest rates, Blinder says, the Fed is once again trying to stimulate economic activity. It hopes people will see how low rates are and rush out to buy things.

"Cars are usually financed on a three-year loan, for example, and here we've had the Fed saying overnight rates are going to be near zero for two years. That's two-thirds of that period," he says.

The problem is the Fed has already cut interest rates to historic lows, and they can't get much lower. Still the economy is limping along and the stock market plunge is likely to make things worse.

Back To The Drawing Board

Mike Frantoni, of the Mortgage Bankers Association, says in an environment like this cutting rates just doesn't make a big difference.

"Much more important is what's going on in the job market and the fact that we've had really pretty anemic job growth the past couple of months, and the unemployment rate remaining stubbornly high — above 9 percent," he says. "That is really a much more important factor at this point."

Conventional tools just aren't working, Blinder says, and the Fed needs to go back to the drawing board.

"All the good ones have been used; it's down to not-so-good to bad ones," he says. "Those are the choices that are left, but there still are choices left."

So what can the Fed do? Blinder says one idea is to cut the interest rate it pays for bank reserves.

"The Federal Reserve is a bank for banks — so the bankers all have what amounts to checking accounts at the Fed," he says. "Usually, they keep very minimal balances in those checking accounts because it earns them nothing. But lately, in this climate of fear, they have been keeping a colossal sum."

Blinder's idea is to sandblast the money out of those accounts by lowering the interest rates banks get.

"I'd like to see that drop to zero as a first step, and then I'd actually like to see it go negative — charge banks for the privilege of storing the stuff there," he says.

If banks could no longer stash their money at the Fed cheaply, Blinder says, they'd have more incentive to loan it to businesses and consumers.

Helping Underwater Homeowners

The Peterson Institute's Gagnon has another idea. He says many homeowners are now underwater on their mortgages, owing more than their homes are worth. He says the Fed could work with the Obama administration to ease restrictions on refinancing.

"So why don't we reduce the taxpayers' risk by letting these people refinance into a cheaper mortgage," Gagnon says. "That reduces the risk they will default in the future. It makes them more able to spend and consume in the economy now."

That would be risky, he concedes. Because the federal government backs Fannie Mae and Freddie Mac mortgages, it would essentially be on the hook in case the housing market weakens further.

That would be politically unpopular. But with conventional measures largely exhausted, the Fed is having to consider unorthodox ways to get the economy going again.

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