(MintPress) – Wednesday, Ben Bernanke, chairman of the Federal Reserve, announced that the Fed plans to keep interest rates near zero in response to the national unemployment rate. Connecting corrective action to an economic marker for the first time, instead of a timescale, Bernanke has announced that interest rates will stay low at least until the unemployment rate drops below 6.5 percent — a threshold the bank doesn’t expect to cross until fourth quarter 2015.
Based on the Federal Open Market Committee’s (FOMC) projection that inflation will stay at or below 2 percent, Bernanke has also announced that the Fed will continue to purchase mortgage-backed securities. The purchase scheme, which will be added to the Fed’s investment portfolio, started in September and has a purchase rate of $40 billion in bonds per month. The Fed, in its “Operation Twist”, which also started in September, is currently buying short-term bonds for long-term bonds. This “maturity extension program” is a modern take on a program initiated under the Kennedy administration, in which short-term bonds are taken off the market, lowering the long-term rates and forcing investors to seek substitute securities — such as stocks.
The United States Federal Open Market Committee is a component committee within the Federal Reserve System that is responsible for regulating the nation’s open market policies; that is, the buying and selling of Treasury securities, setting interest rates and enforcing the national monetary policy.
“Operation Twist” is currently buying back at $45 billion a month. It is expected to expire at the end of the month, but Bernanke has suggested he is interested in extending it. In part due to the lowering of long-term rates, the housing and mortgage markets have started to rebound. The buyback is twofold: First, the Fed sells off or redeems a proposed $667 billion by the end of 2012 in shorter-term Treasury securities. Second, the Fed uses the proceeds from the redemption and purchases longer-term securities, taking them off of the market. The scarcity of the remaining bonds drops the long-term interest rate, which is a key consideration on multi-year loans and mortgages.
During the press conference Wednesday, Chairman Bernanke said:
“… The goal of the asset purchase program is to increase the near-term momentum of the economy by fostering more accommodative financial conditions, while the purpose of the rate guidance is to provide information about the future circumstances under which the Committee would contemplate reducing accommodation. I would emphasize that a decision by the Committee to end asset purchases, whenever that point is reached, would not be a turn to tighter policy. While in that circumstance the Committee would no longer be increasing policy accommodation, its policy stance would remain highly supportive of growth. Only at some later point would the Committee begin actually removing accommodation through rate increases …”
The Federal Reserve System, as the national central bank, is charged — as stated in its mission statement — with the avoiding banking panics, managing the national monetary supply via the enforcement of policies meant to maximize employment, stabilizing prices through the avoidance of inflation or deflation and moderating long-term interest rates.
With the new long-term security purchases, the Fed’s investment portfolio will swell by nearly $1 trillion from the $3 trillion it is as of now by the end of 2013 if “Operation Twist” stays in place. As of today, the portfolio is triple what it was prior to the recession.
Reactions in regards to the Fed’s announcement were mixed. After hearing Bernanke’s comment, the Dow Jones industrial average (DJIA) fell three points. The Standard & Poor’s 500 (S&P 500) index rose marginally.
Globally, the reaction was equally muted. The euro fell 0.1 percent to $1.3060 on news that European Union finance ministers accepted a plan to create a banking supervisor and that Greece approved plans to accept more bailout money. The FTSE 100, still wobbling on news of the impending “fiscal cliff” here in America, dropped 0.3 percent to 5,931 while, in Germany, the DAX dropped 0.4 percent at 7,587. France’s CAC-40 fell 0.1 percent at 3,645.
The Fed believes that this move will benefit consumers and borrowers, as less speculation about interest rates will allow for more accurate fiscal planning. Many skeptics pan this plan. Interest rates have been near zero since the recession started in the fourth quarter of 2008. Continuing this course now would have little to no effect on the borrowing rates. In addition, credit standards are still tight and bank lending is still slow; a low interest rate on a mortgage is nice, if you can get the loan in the first place.
Jeffrey Lacker, president of the Federal Reserve Bank of Richmond and the sole governor to the Federal Reserve Board to reject continuing this stimulus plan, feels that employment levels are being controlled by factors outside of the Fed’s control, and that influencing the market through bond purchasing risks future inflation.
The larger concern lies with who will benefits from all of this the most. In light of a lethargic Congress, the Fed can only influence the economy so much. The Fed predicted a 3 percent growth to the economy next year, 3.5 percent in 2014, and 3.7 percent in 2015. Unemployment rates are to remain at least at 7.4 percent by the end of 2013, and at least 6.8 percent by the end of 2015. Those who live off of savings, such as the elderly, are expected to get hit the hardest, as lower interest rates means slowed rates of growths for saving accounts.
However, the forced scarcity of long-term securities offer a boom to stocks, which are generally seen as a riskier alternative to Treasury-issued securities. In the scarcity of safer bonds, more and more will turn to stocks, which lost some of their appeal after the housing bubble collapse. The increase in stock purchasing will raise stock prices, creating a glut of wealth among the more prolific investors. While this will improve the economic profile of the nation, it will be such a localized economic expansion that most Americans will barely notice, at first.
It is hoped that this will have a domino effect: More investors and businesses will notice the “glut” and choose to invest, which will lift stock prices universally. This would invest even more investors, and ultimately, the economy would gain increased forward momentum.
Enthusiasm for this, however, has been tempered by the upcoming “fiscal cliff,” which could undermine any corrective measure the Fed proposes. While many agree that loosening monetary policy in the age of austerity is contradictory and self-defeating, the imposition of massive government cuts and huge tax hikes promise to freeze consumers’ enthusiasm to invest, strangling any economic growth. Thomas Lam, group chief economist at OSK-DMG in Singapore, writes:
“A one-size-fits-all fiscal policy approach (in the current context, fiscal tightening is the norm) is not only misguided but extremely dangerous for the global economy as it remains more-or-less stuck in the mud. Policymakers, especially in economies with subdued sovereign risk premiums (like in UK, US, Germany and Japan for instance), need to consider the notion of fiscal flexibility – a combination of near-term, though temporary, fiscal boost coupled with the commitment of longer-term fiscal tightening.
“Without some degree of fiscal flexibility, monetary policy bears the entire brunt of keeping an economy above water. And eventually, the costs of pursuing nonstandard monetary policy would outweigh its benefits. To be sure, while central banks never run out of ammunition in theory, there are limits to monetary policy in reality.
“Indeed, when politics overshadow economic objectives, like in the current environment, the economy suffers eventually.”
What happens to the dollar if we go over the cliff?
The “fiscal cliff,” or the enforcement of a series of sequestrations — or automatic cuts — called for in the Budget Control Act of 2011 and the scheduled termination of tax cuts introduced during the administration of George W. Bush, threatens to destabilize the economy in an indiscriminate manner, with severe cuts to nearly every component of governmental operation and — on average — more than $3,300 less in take-home wages per middle-class American family. At midnight New Year’s Day, unless the Budget Control Act is amended or repealed and unless the president consents to the extension of the Bush-era tax cuts, full, European-style austerity will finally come to America.
The Congressional Budget Office (CBO) projects that, under the current scheme of tax hikes and budget cuts, the government will save $607 billion gross between 2012 and 2013, including $221 billion saved from implementation of the Provisions of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010; $95 billion from the Middle Class Tax Relief and Job Creation Act of 2012; $26 billion from the expiration of extended unemployment benefits; and $11 billion from reductions in payment rates for physicians under Medicare. Due to an expected economic contraction, the deficit will increase by $47 billion (mostly, to cover expenses such as increases in unemployment compensation claims and additional coverage for increased enrollment to programs such as Temporary Assistance for Needy Families), so the net savings projected for 2012-2013 is $560 billion.
Fitch Ratings has projected that unemployment would rocket past 10 percent under this situation. Additionally, $55 billion would be cut from Defense spending, hitting as many as 500,000 jobs in the Beltway. With new budget cuts, federal departments will be forced to shrink, and large numbers of federal employees will find themselves jobless. According to a report from Rep. Norm Dicks (D-Wash.), who is the ranking Democrat in the House Appropriations Committee, the Transportation Security Administration can lose 7,240 jobs, Border Patrol 6,800 and the Department of Homeland Security 24,500.
Businesses already having to readjust for the Affordable Care Act may collapse under the new taxes that will be imposed on them. Families already on the edge will fall into poverty under the new tax reality.
Money for national security and grants to fund public and private innovation would be eliminated. Enrichment programs, such as the National Endowment for Arts, the National Endowment for the Humanities, the National Science Foundation and the Corporation for Public Broadcasting, will be hit. The nation’s support programs, such as Amtrak (the National Rail Passenger Corporation) and the United States Postal Service, will not receive the emergency funding needed to keep them afloat.
In all, falling off the “fiscal cliff” will be nothing short of a disaster. Allowing the financial plan to play out as written may lead to a healthier economy 20 or 30 years down the line; but, in the short-term, the gains of the last four years would be lost and the country would be forced to deal with both governmental and private-sector financial stagnation that will drag the country into recession, and possibly, depression.
Under the “fiscal cliff,” the dollar will tank. But, it will not go alone. As the dollar is a key component of many nation’s economic portfolio, the collapse of the dollar threatens to destroy the world’s economy. In the United Kingdom, analysts are carefully watching the political negotiations over the “fiscal cliff,” an agreement before the end of the year will make risk taking more appealing to investors, which will temporarily weaken the dollar to the British Sterling. The U.S. dollar is and will remain the world’s reserve currency of choice. As America goes, so does the world.
While corrections by the Fed is a good gesture, in light of political gridlock, it’s not enough to set right the economy. Ultimately, the momentum and trajectory of the American economic system is determined by Congress and the president; the Fed can only steer.
Nigel Gault, chief U.S. economist of IHS Global Insight, best put the situation, “I don’t think (Fed action) makes a huge difference, but it’s a question of do they do something rather than nothing. It probably is best to do something.”