Fed surprises with darker outlook, promise rates will stay low

WASHINGTON — America's economic conditions have worsened to the extent that a key lending rate in the economy probably will stay near zero at least until mid-2013, a divided Federal Reserve announced Tuesday in a statement that promised action to keep the economy moving forward.

Citing "considerably slower" economic growth than had been projected, the rate-setting Federal Open Market Committee, with three dissenting votes, said it anticipated keeping the benchmark federal funds rate near zero until well after the next presidential election.

That rate, which banks charge each other, is the basis on which banks set the prime rate they charge their best customers. The rate has been near zero since December 2008, and the first-ever target date offered for this record low rate signals that lending interest rates will remain low for quite some time as an impaired economy struggles to regain footing.

"This is an exceptionally dovish Fed statement that downplays the inflation risks and significantly downgrades the Fed's assessment of economic growth," forecaster RDQ Economics said in a research note.

Stocks had been trading up most of the day until the Fed's announcement, but they turned sharply south after the statement was released. As markets digested what the Fed had done, however, stocks stampeded upward at the close of trading, recovering much of Monday's steep losses.

The Dow Jones industrial average rallied 429.92 points, or 3.98 percent, to close at 11,239.77. The S&P 500 fared even better, gaining 53.07 points, or 4.74 percent, to finish at 1172.53. The tech-heavy NASDAQ soared 124.83 points, or 5.29 percent, to end at 2482.52.

The rally came too late for crude oil. Prices for next-month delivery settled down $2.01 to $79.30 on the New York Mercantile Exchange, falling 17 percent so far this month. That's bad for investors but good news for weary motorists and energy-intensive businesses such as truckers and airlines.

In practical terms, the Fed's statement Tuesday drove down the interest rate the Treasury Department pays investors who purchase two-year government bonds. That low return encourages investors to seek better returns in the market for stocks, bonds or commodities and promotes risk taking and economic activity. It amounted to a creative way for the Fed to boost the economy.

While earlier Fed statements spoke to head winds slowing growth, Tuesday's suggested that these weak underlying fundamentals might have been masked.

"Temporary factors, including the damping effect of higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan, appear to account for only some of the recent weakness in economic activity," the Fed statement said.

It painstakingly listed the weaknesses:

"Indicators suggest a deterioration in overall labor market conditions in recent months, and the unemployment rate has moved up. Household spending has flattened out, investment in nonresidential structures is still weak and the housing sector remains depressed."

Given the turmoil in financial markets over the past week, the markets were expecting that the Fed at minimum would change its language of past statements to pledge the exceptionally low rates for a defined period.

Few analysts, however, expected a pledge to keep rates so low for so long. The announcement came with an almost unheard-of three dissents among the 10 committee votes. The presidents of the Federal Reserve Banks of Philadelphia, Dallas and Minnesota preferred more ambiguous language promising an "extended period" for near-zero rates, rather than a hard date.

Despite market turmoil tied to last Friday's embarrassing downgrade of U.S. government bond ratings, the Treasury Department sold $32 billion in three-year Treasury notes Tuesday at record-low interest rates. It was the first Treasury auction since Standard & Poor's took away the gold-plated AAA rating, and it suggested that investors still see U.S. bonds as the safest in the world.

The Fed pledged to keep reinvesting the earnings from the vast securities it had purchased earlier to stimulate economic activity. It also restated that it'll review the size and composition of its holdings as needed.

"The committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate," the Fed said, keeping its options close to the vest.

Among the tools the Fed is thought to be considering is lowering the interest rate it pays on the cash that private banks keep in the Fed system. Like Tuesday's action, this would create a disincentive to sit on cash, encouraging banks to invest and lend in support of the economy.

Another option is to lengthen the maturity of securities the Fed holds, driving down long-term lending rates in the economy. That, in turn, would drive down mortgage rates to the benefit of commercial real estate, homebuyers and refinancing of mortgages.

Faced with a slide back into recession, analysts expect that Fed Chairman Ben Bernanke would purchase even more assets to spark investment and lending. The chairman may shed more light on his options at a speech Aug. 26 at the Wyoming resort city of Jackson Hole.


FOMC statement


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