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The Fed’s Disappointing No Exit Announcement

Daniel Gross

The stock markets and the American people aren't the only ones who have become more pessimistic about the prospects of the U.S. economy in the coming months. The Federal Reserve has joined them.

The Federal Open Market Committee, the arm of the central bank that sets interest rate policy, released a statement that was poised to answer two questions. First, what is the Fed's assessment of the economy? And second, what actions is it prepared to take to help boost economic growth and employment?

Now we've got the answers: Poor, and not much.

The Fed starts by joining the rest of the world in striking a more bearish tone on economic growth and unemployment. Data it has reviewed since it last met in June shows "that economic growth so far this year has been considerably slower than the Committee had expected." In addition to a punk labor market, "household spending has flattened out, investment in nonresidential structures is still weak, and the housing sector remains depressed."

The good news? Business investment is rising, and the Fed is feeling more comfortable that inflation is coming under control, thanks in part to the recent fall in oil prices.

Given low inflation and rising "downside risks to the economic outlook," the FOMC concluded that action is required. But in this instance, the Fed has chosen non-action. Rather than embark upon a third round of so-called quantitative easing (buying bonds or mortgage-backed securities in an effort to push down rates), or kick off an innovative effort to intervene in the markets, the Fed is simply promising to stand pat -- for a long time.

The FOMC said it would keep the target federal funds rate at between 0 and 0.25 percent, where it has been since December 2008. And -- here's the news -- given the current environment, it is promising to keep them at this level "at least through mid-2013." In other words, the central bank is committing to keeping the interest rates it controls at this exceedingly low level for another two years.

That is extraordinary on a few levels.

First, the Fed is intentionally creating an environment in which short-term interest rates -- for borrowers, for savers, for companies -- will be exceptionally low. The fed funds rate target has been at the current level for coming up on three years, as this chart indicates. Pushing the zero-interest rate policy out till mid-2013 would create a four-and-a-half-year period of near-free money for banks. Unprecedented.

Second, in the spring, chatter was building about how the Fed might be able to exit from its post-crisis interventions. As we've noted, with the end of the most recent round of quantitative easing, the Fed's balance sheet has already started to shrink a bit. But now the Fed is signaling that there will be no exit to the zero-interest rate policy any time soon.

In telegraphing policy two years out, the Fed is showing a high degree of confidence in its own visibility. It is essentially saying that the economy will be sufficiently fragile for the next 24 months that it wouldn't be able to withstand an exit from the current policy, and that it is sufficiently confident that inflation won't prove problematic in the interim. To be sure, such a pronouncement provides certainty. But it's worth noting that the Fed has not been particularly clairvoyant in the past. Its record at predicting turning points in the economy is just as poor as that of any other forecaster. And the world has a way of springing surprises -- positive and negative -- on the best central planners.

Third, this decision was somewhat controversial. Usually, FOMC moves have the unanimity of Soviet-era Russian Politburo gatherings. Every other statement the FOMC has issued this year has been unanimous. But this time, three members dissented -- Dallas Fed President Richard Fisher, Minneapolis Fed President Narayana Kocherlakota and Philadelphia Fed President Charles Plosser. While they agreed rates should remain low, they were against putting a specific date on the commitment.

To a degree, this statement is confirmation of a growing consensus in the markets: Economic growth in the near future is likely to be less robust than previously thought. More troubling, it confirms that the Federal Reserve, which was so imaginative and aggressive in dealing with the crisis in 2008 and 2009, has adopted a position of relative passivity during the recovery.

Markets rallied strongly Tuesday morning, partly on the hopes that the Fed would reveal a new effort to aid the economy. Instead, we got more of the same. It's not surprising stocks fell after the Fed's announcement.

Daniel Gross is economics editor at Yahoo! Finance.

Email him at grossdaniel11@yahoo.com; follow him on Twitter @grossdm.