The Fed's big policy move: What it means

(MoneyWatch) The Federal Reserve concluded its last monetary policy meeting of 2012 with a bang. The central bank said it would allow "Operation Twist" to expire at year-end and replace it with monthly purchases of $45 billion of long-term Treasury bonds in order to keep long term interest rates low. Additionally, the Fed will begin using specific unemployment and inflation rate targets to guide future short-term interest rate policy.

Long-term interest rate policy: Since the financial crisis, the Fed has used the purchase of bonds ("Quantitative Easing" or "QE") in order to keep longer interest rates low. The idea behind QE is that the Fed buys U.S. Treasury bonds and mortgage-backed securities, which drives up prices, pushes down interest rates and reduces the availability of these bonds in the market. With fewer bonds available, investors turn to alternate assets, like corporate bonds. When the original QE was announced in March 2009, the economy was shrinking by an annualized rate of 5.3 percent and companies were having difficulty borrowing money. QE helped grease the wheels of corporate credit and helped the economy function more normally.

When QE2 was announced in 2010, corporate credit was not the issue, but a downshift in economic growth was worrying the Federal Reserve. The second round of QE was seen as a way to lower long-term rates, which would encourage more borrowing and spending, which would in turn (hopefully) create more economic growth. Operation Twist, which was implemented in September 2011, was a variation on QE. Each month, the Fed sold $45 billion worth of short-dated government bonds and bought an equal amount of government bonds with longer maturities. This fall, the Fed launched QE3, with an open-ended commitment to purchase $40 billion of mortgage-backed securities each month.

Operation Twist was set to expire at the end of this year and although the new policy has a similar goal and uses the same $45 billion target, there is a big difference: The new policy expands the Fed's balance sheet. As of last week, the Fed's portfolio was $2.861 trillion and now it will balloon until the central bankers believe the economy is on firmer footing and the labor market substantially improves. At that point, the Fed would sell the assets on the balance to remove liquidity from the system and hopefully prevent inflation from rearing its ugly head. Critics fear that the Fed will not be quick enough to sell assets and fight future inflation; and the sale of trillions dollars of bonds on the market would likely drive up interest rates and slow down the economic recovery.

Short-term interest rate policy: For nearly four years, the Fed has kept short-term interest rates at 0-0.25 percent and has said that rates would remain low until mid 2015. In today's announcement, the central bank has introduced a new communications strategy: It will use hard unemployment and inflation targets to help guide short-term interest rate policy.

Going forward, the Fed expects rates to remain very low as long as the unemployment rate remains above 6.5 percent and inflation "between one and two years ahead is projected to be no more than a half percentage point above the Committee's two percent longer-run goal, and longer-term inflation expectations continue to be well anchored."

While the change has been telegraphed by Fed governors recently (Fed Vice Chairman Janet Yellen recently called for specific thresholds to guide policy), this is the first time in the central bank's history that he conditions under which it expects to keep rates low. Whether these new thresholds will be more effective than the previous "date-based guidance" for policy remains to be seen.

Bottom line: The Fed continues to pull out all the stops to provide the economy with liquidity. But with demand and economic growth in low gear, it's not clear that the central bank has the tools necessary to boost growth.

[inketolstoy]

So not only will our government continue to kick the cans of medicare, social security and the national debt down the road, but the fed will also accelerate inflation by creating more debt to hide inflation and its resulting affects on a weak economy. Short term this makes sense, but long term it is disastrous. While do visions of Germany in the late 20's keep popping into my mind?

[taxed01]

To all you seniors who did the right thing and saved for retirement and expected to be able to have some interest from your savings to live on - Here is a big SCREW YOU from the Obama administration.

[nearl451]

It means no news and still stupid "automatic" levels. I still say Bernanke never had any courage.

Why do we hire people to think when automatic triggers are employed?

[kbbpll]

Can I buy back my own debt using borrowed money too? And where can I get that short-term loan for 0% interest? I only need to start printing my own money, and I'm golden! Sheesh, I think I just joined the tea party.

[Ulgnud]

SPEND $45 billion a day to keep interest rates low? What kind of horse puckey is this? Cut the spending of money we don't have and simply keep interest rates where they are needed. Better yet, since there is no Constitutional authority for the federal reserve to exist, get rid of it. According to the US Constitution, Congress is tasked with regulating our currency. Make them do their job. (That last part alone may be a challenge.)

[get_down]

Well, this article's title is "The Fed's big policy move: What it means". We all know since 2008, FR has launched QE1, QE2, QE3, Operation Twist and now QE4. Has any QEX ever worked - I mean in terms of helping reduce our economic woes at all? Frankly I don't think so. But hey, don't just take my word for it. Ask those 12 million unemployed anxious and heart-broken Americans the question "Does any FR's QE operation help you land a job you want?" I'm willing to bet my whole assets (which I earned from more than 29 years of my hard-working tenure) on its answer that majority would say "No". Everyone knows that consumer spending accounts for 70% of the economic growth. With key interest rate set by FR since 2008 close to zero and how would that going to boost consumer spending? I said all along that Federal Reserve Chairman Ben Bernanke is not only incompetent but also clueless to the Nth degree because he has proven that he has no comprehension of the word "Logic" which is a mathematical term. Well, Mr. Obama has his Second term as POTUS and looks like he would award Mr. Ben Bernanke his Third term as FRC. In the meantime, we are doomed. That is "What it means"!

[inketolstoy]

It doesn't look like the assets you earned in 29 years will be worth near as much as you might have hoped in the next 15 years.

[venusvegasvada]

What it means is the Fed is still doing Congress's job for them.

Congress is supposed to be the branch passing a budget each year and deciding on fiscal matters. Oops, that's right. This congress hasn't passed a budget in what? 4 years? The only reason the Fed got drug into this mess was because Congress did NOTHING and the economy would have been flushed down the toilet without their intervention. But hey, it keeps the Tea Party in there and they still manage to dodge the blame for it.

Oh, sorry, I forgot the Congress's steady output of endless attempts to "kill Obama/RomneyCare" and go on fun filled skinny-dipping trips to Israel.

[tsigili]

They are still devaluing the currency, and reducing the consumer's purchasing power, effectively making the consumer earn less.