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More of the same medicine from the Fed

September 13, 2012

| MoneyRates.com Senior Financial Analyst, CFA

If you are ailing, and you take a medicine that doesn't work, do you up the dosage or try something else?

For Ben Bernanke and the Federal Reserve, the answer seems clear: More is always the way to go.

An open-ended commitment

In the meeting of the Federal Open Market Committee that concluded September 13, the Fed decided on another round of quantitative easing -- QE3, for those of you keeping score.

In essence, the Fed is lengthening its commitment to low interest rates. It is now saying that it sees a likelihood of keeping the Fed funds rate at "exceptionally low levels" at least through the middle of 2015. Also, in announcing that it will make additional purchases of mortgage-backed securities, the Fed did not use a timetable or total amount to describe the extent of this new program -- it merely made an open-ended commitment to purchase additional mortgage-backed securities at a pace of $40 billion per month.

Over the past year, the Fed has put a great deal of emphasis on how it communicates its policies, and it is significant that the Fed is now signalling that low interest rates are here to stay for the foreseeable future. Having lowered interest rates about as far as it can, the Fed is now hoping to get extra psychological mileage out of the message that people can expect these low rates to continue for a long time.

Three problems with the policy

The stock market got a quick fix out of the announcement, but it is important not to confuse the market's interests with the broader well-being of the economy. There is some overlap, of course, but stock valuation formulas yield higher prices when interest rates are low. Given how short-sighted most stock investors are, the promise of more low interest rates is enough to spark a rally, regardless of whether it ultimately helps the economy.

Meanwhile, there are at least three reasons to believe that more of the low-interest rate approach won't help:

  1. It is robbing savers of interest. Take money out of the pockets of people with savings, and you take money out of the economy.
  2. If creates a disincentive to lend. Low interest rates are supposed to create an incentive to borrow, but it takes two to tango. Loan volume has been weak since the low interest rate program began. Could the connection be that low rates offer an inadequate reward for the risk of lending?
  3. It is vulnerable to an inflation shock. The Fed notes that it is able to extend its policy because inflation has been tame. However, inflation is always just one new crisis away -- and rising tensions in Libya and Egypt are the latest reminder.

The first two of these may have prevented the economy from responding to the Fed's medicine in the first place. The last could be what closes out that prescription once and for all.

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