Fed Sees Growth by Year End

With nowhere to go on rates, policymakers go shopping for debt of all stripes to help solve the credit crisis.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

January 28, 2009

Federal Reserve policymakers see the recession ending later this year. But the economy will get worse before it gets better. That was the upshot of a statement from the Federal Open Market Committee, the Fed’s policymaking arm, on Jan. 28. The FOMC voted 8-1 to keep short-term interest rates unchanged at virtually zero.

In light of that view of the economy, the nation’s central bank plans to continue buying billions of dollars worth of mortgages, commercial paper and other debt to help keep interest rates low.

The Fed is creating a brave new world. For decades, the attention of the financial markets focused on whether Fed policymakers raised or lowered the federal funds rate -- the rate banks charge each other for overnight loans. It has long been the basic tool in shaping monetary policy. That changed in December, when the Fed cut that rate to a narrow range between zero and 0.25% and said it would keep the rate there "for some time."

Investor attention now focuses on how the Fed characterizes economic conditions and whether it announces any new purchases of securities in its ongoing efforts to restore normalcy to nearly frozen credit markets.

The Fed will continue to buy mortgage-backed bonds and short-term debt issued by corporations as well as debt backed by student loans and certain other assets. The goal is to thaw credit markets in order to keep a bad recession from getting far worse.

There are a few signs of improvement. Some short-term rates have fallen, and banks are lending to one another. But the banks aren't lending much at all to businesses and households. First quarter gross domestic product, due out Jan. 30, will probably show a contraction of around 5%, and the current quarter is on track to be almost as bad. The Fed is counting on its actions plus a nearly $1-trillion fiscal stimulus to end the recession later this year.

But the Fed is somewhat worried about the risk of deflation if the recession lasts into 2010. In a speech in London on Jan. 13, Fed Chairman Ben Bernanke explained various steps that the Fed has taken and suggested that more are possible. "Although the federal funds rate is now close to zero, the Federal Reserve retains a number of policy tools that can be deployed against the crisis," he said. Some that he mentioned include buying longer-term bonds, both Treasuries and corporates, if needed to keep long-term interest rates from rising.

Bernanke and Co. are closely watching the yield on 10-year Treasury bonds. That rate affects fixed rate mortgages as well as corporate bonds. The Fed wants to keep long-term rates as low as possible, but they've risen about half a percentage point over the past month. The next FOMC meeting is scheduled for March 17.

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