Fed Lowers U.S. Outlook; Pledges Low Interest Rate to Continue

After three days of wide-spread losses the Federal Reserve was left with little choice but to take to the airwaves in an attempt to calm jittery nerves. Reassurances given, markets responded positively. The Dow Jones Industrial Average closed the day with an advance of nearly 430 points or 3.9 percent. Unfortunately, Tuesday’s “relief rally” was short-lived and by 12:30 Wednesday afternoon the Dow had returned most of yesterday’s gains.

In Tuesday’s press release, Federal Reserve Chairman Ben Bernanke confirmed that the Fed will keep ultra low interest rates though to at least the middle of 2013. It’s one thing to pledge to follow a specific policy, but to include a precise time frame for the action is unusual – especially one that extends out nearly two years.

This is a telling commentary on the Fed’s long range outlook for the U.S. economy. The fact that the Fed feels a near-zero interest rate policy will be necessary so far into the future reveals the Fed’s belief that little improvement is likely before the end of next year at the earliest:

“The Committee now expects a somewhat slower pace of recovery over coming quarters than it did at the times of the previous meeting and anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, downside risks to the economic outlook have increased.”

In order to meet its “dual mandate” of ensuring full employment together with price stability the Fed noted that is has a “range of policy tools” at its disposal. This will include continuing to reinvest principal payments from the Fed’s security holdings back into the economy, but it also opens the door to further quantitative easing.

To date, the Fed has completed two rounds of quantitative easing. The first round added over a trillion dollars to the Fed’s balance sheet which was then placed into the financial system as “new” liquidity; the second round of QE spending wrapped up earlier this summer and reinvested a total of $600 billion. Faced now with a slowing U.S. economy and the debt crisis in Europe, odds are tipping in favor of the Fed introducing a third round of quantitative easing.

Growing Dissent Within the Fed

Noticeable in yesterday’s update is the fact that three of the twelve voting members voted against promising to hold interest rates for another two years. Dallas Reserve President Richard Fisher and Philadelphia Reserve President Charles Plosser both withheld their support. Given their reputations as interest rate “hawks” supporting higher interest rates, this does not come as a surprise.

However, when Narayana Kocherlakota, President of the Minneapolis Reserve Bank, opted to side with the hawks, this marked the first time more than two voting members have lined up against Bernanke. Even so, the statement was easily supported by a strong majority of the voting members but the possibility of growing dissent at the FOMC will be watched very closely in upcoming statements.

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