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A slow turn in Fed policy

| MoneyRates.com Senior Financial Analyst, CFA
min read

They say nothing takes longer to turn around than an oil tanker. Federal Reserve policy might give those boats some serious competition.

The Fed concluded its latest meeting today with an announcement that indicates the transition from stimulative to neutral policies is continuing -- just very slowly. With the economic recovery still in uncertain health more than five years after the end of the Great Recession, you could argue about how effective the Fed's policies have been, but for that same reason, their reluctance to make any sudden changes is understandable.

The latest Fed policy changes

Low interest rates are a traditional monetary tool for stimulating the economy, and the Federal Reserve has lowered both short-term and long-term rates. While the Fed has a fair amount of direct control over short-term rates, it had to influence long-term rates by buying long-term bonds. It is this long-term rate policy that the Fed has been backing away from throughout this year.

Continuing the pattern from recent meetings, the Fed announced that it will trim those purchases by another $10 billion per month, leaving the total ongoing purchases at $15 billion. Thus this tactic to bring down long-term rates has almost run its course, though until the Fed starts selling the securities it has already accumulated (or at least letting them mature without reinvestment), there may not be immediate upward pressure on long-term rates.

As for short-term rates, the Fed is keeping them firmly near zero, and anticipates continuing to do so for a "considerable time" after its asset purchases have ceased. For consumers, this means mortgage rates are more likely to rise than savings account rates.

How healthy is the economy?

The shift -- subtle though it is -- in Fed policy is based on the premise that the economic recovery is strong enough to survive without some of the stimulative support it has been receiving from the Fed. Unfortunately, some recent developments have cast some doubt on this premise:

  1. Employment growth for August was below par.
  2. Purchase mortgage applications recently fell to their lowest level since February.
  3. Consumer prices declined in August.

When the Fed has kept the economy on life support for so long, it is worrisome to see the patient gasping for breath when just a little of that life support has been removed so far.

Why not just keep a foot on the gas?

If the economy is in questionable health, why not just keep stimulative policies in place? It may be that the Fed is worried about the build-up of the type of excesses that led to the financial crisis six years ago. The stock market has soared to record highs on the strength of low interest rates, and borrowing in many forms has also reached record levels.

Therefore, the Fed may be looking for a formula that encourages economic growth without encouraging risk-taking. That has always proven to be a difficult balance to achieve.

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