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Fed promises two years of low rates Add to ...

The U.S. economy will require life support for as much as two more years, as the Federal Reserve acknowledged what investors have been saying for days as they sold stocks around the globe: that a sustained recovery from the financial crisis of 2008 remains elusive.

High unemployment, tapped-out consumers and a depressed housing market led the Federal Reserve to say Tuesday that the outlook for recovery in the world’s largest economy is now so tepid that short-term interest rates will probably remain at emergency, near-zero levels until mid-2013.

Pledging a two-year commitment is unprecedented for the world’s most influential central bank, and the 2013 timeline would mark almost half a decade of holding borrowing costs as low as possible. The Fed cut its benchmark rate to the historic low of 0 per cent to 0.25 per cent in December, 2008, in response to the financial crisis – and has held it there ever since.

The hope was that the low rates would foment a sustained recovery by making it cheap to borrow money to go shopping or build a new factory. For a time, it seemed to work, with economic growth picking up by early 2010 and unemployment starting to come down. U.S. stocks had surged in a rebound from the 2008 crash.

However, recent numbers show the U.S. recovery seems to have plateaued, and that is one of the big factors sparking a steep plunge in global stocks in the days leading up to Tuesday.

“It’s unprecedented action for unprecedented times,” said Craig Wright, chief economist of Royal Bank of Canada, of the Fed statement.

Setting out a specific timeline borrows a policy tool used by the Bank of Canada in 2009, when Governor Mark Carney made what the central bank called a “conditional commitment” to keep its benchmark rate low until the middle of 2010. The Bank of Canada now says there is evidence that suggests committing to keep rates low was effective in lowering other interest rates in Canada more than otherwise would have been the case.

Stock market investors weren’t sure at first how to take the Fed’s announcement, and many shares slid once again in the moments following the early afternoon decision Tuesday, before benchmark indexes turned around and ended the day with a huge rally. The Standard & Poor’s 500 index of the biggest U.S. stocks rose 4.7 per cent. Canada’s S&P/TSX Composite Index surged 438.3 points, or 3.8 per cent, to 12,109.26, erasing most of Monday’s loss.

In addition to keeping short-term rates low, the Fed said it won’t cut the size of its vast holdings of U.S. government bonds, which it had purchased to try to drive down longer-term interest rates.

Rates are now so low in the U.S. that some banks are charging customers with large deposits, rather than paying interest.

If that’s not enough, the Fed’s rate-setting committee said it is ready to employ other unspecified “tools” to try to spur expansion if growth continues to disappoint.

Three members of the 10-member rate-setting committee dissented from the decision to give a specific end date for rock-bottom rates. Dissent is not new on the Fed’s rate-setting committee, but having three people disagree marks the biggest split in almost 20 years. During the height of the financial crisis in 2007 and 2008, there was a string of Fed meetings with two dissenters. Richard Fisher and Charles Plosser, two of those who split from Mr. Bernanke Tuesday, have disagreed with the committee in the past. They have both been concerned that the Fed might let inflation get out of control if it keeps interest rates too low for too long.

Now, the question markets are grappling with is whether the split will hamper the Fed’s ability to employ further measures to speed growth if necessary.

The Fed made no mention of the huge sell-off in stocks that occurred in the days leading up to Tuesday, perhaps to avoid giving the impression that it can be pushed around by markets. However, if the drop in stock prices causes a slide in confidence among businesses and consumers, or a drop in spending because people feel poorer, the Fed may have to act.

“This is the first step,” said BMO Capital Markets economist Michael Gregory. “If the soft path persists and becomes more entrenched owing to the crisis of confidence which has manifested itself in recent weakness and/or volatility in financial markets, the Fed could take the next step.”

The Fed acknowledged that the economic outlook had darkened since late June, the last time the central bank gave a statement. Growth so far in 2011 “has been considerably slower than the committee had expected,” and there’s no sharp pick-up in the forecast as the central bank said it expects a “somewhat slower pace of recovery over coming quarters.” On top of that, “downside risks to the economic outlook have increased.”

In good times, the U.S. economy has often posted numbers better than 3 per cent. In the post-bust U.S., few people expect such numbers, but even so, growth rates below 2 per cent are a big disappointment.

Since 2008, the job market has been soft, with unemployment still at 9.1 per cent. That, combined with a housing market that just keeps falling, has led households to become more frugal – a huge roadblock for an economy that gets two-thirds of its GDP from consumer spending.

The Fed’s announcement comes after a string of weak economic indicators in the U.S. The most damaging number was probably the statistic late last month showing that economic growth in the second quarter was 1.3 per cent, and that the first-quarter number had been revised down from the originally reported 1.9 per cent to a barely conscious 0.4 per cent.

The implications of the U.S. situation are likely to mean slower growth in Canada as well. Markets have decided in the past few days that Mr. Carney won’t be raising Canadian short-term interest rates any time soon, even though he signalled last month that this is what he planned to do.

“You have to revisit the outlook for Canada growth and the outlook for the Bank of Canada,” Mr. Wright said.

Follow on Twitter: @boyderman

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