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Stock markets celebrate, but Fed finds reasons to worry about fiscal policy
The Federal Reserve on Wednesday pleasantly surprised financial markets by deciding not to start withdrawing the easy money policies it has maintained since the Great Recession of 2007-2009.
The Fed decision to stand pat and not start paring back $85 billion a month in purchases of Treasury bonds and mortgage-backed securities sparked an immediate stock rally that sent the Dow Jones industrial average and blue-chip Standard & Poor's 500 stock index to record highs. The Fed's lenient policies have been an elixir to financial markets worldwide, with the Dow soaring 147 points to 15,677 and the S&P 500 hurtling 21 points higher to 1,730.
The Fed appeared to be keeping one eye on Congress in deciding not to change course. While underlying conditions in the private economy appear solid, "fiscal policy is restraining economic growth," the Fed's rate-setting committee said in an afternoon statement.
Further, Fed Chairman Ben S. Bernanke said in a news conference that concern about disruptions of government funding as House Republicans and the White House head toward another impasse over budget matters was discussed by the Fed committee in its two-day meeting this week.
"A factor that did concern us was the possibility of a government shutdown and also the debt limit issue," he said, noting that a fight over raising the government's debt ceiling in the summer of 2011 had a "noticeable effect on confidence and the economy" at the time.
Beyond the dampening effects of budget cuts, Mr. Bernanke acknowledged that the Fed's own "taper talk" as he and other Fed officials openly debated whether a tightening was in order in the past three months, has caused a sharp rise in interest rates that has the potential to crimp economic growth, particularly in the housing market. Average 30-year mortgage rates have jumped more than a full percentage point since June to more than 4.5 percent.
Mr. Bernanke expressed hope that the Fed's surprise decision to hold off tightening will help prevent debilitating rises in interest rates, and he said he expects the economy as it continues to recover from the worst debt crisis since the Great Depression will need ultralow interest rates to stay on course for years to come.
"To the extent our policy position today make conditions a bit easier, that's desirable," he said, noting that the big jump in market interest rates this summer was beyond what the Fed expected. "We are going to do what's right for the economy" to keep it on course to achieving a self-sustaining recovery in the months ahead, he said.
The Fed's failure to move came as a surprise to Wall Street's army of Fed watchers, most of whom expected the central bank to pare back its monthly bond purchases to about $75 billion, to slowly start withdrawing liquidity from the economy.
Economists at Zero Hedge Fund called the decision a "shocker."
Justin Wolfers, economics professor at the University of Michigan, called it "the right decision," however, as economic conditions are not strong enough for a withdrawal of Fed support.
While the Fed move stoked a brisk rally in U.S. markets, it was met with elation in battered emerging markets such as India, South Africa and Turkey, where the widespread anticipation of a Fed tightening has sent interest rates soaring and has threatened economic growth.
"The sweet joys of cheap money," tweeted Romit Mehta, an economist in India.
"The Fed has plenty of reason to worry" about a premature rise in interest rates, both here and abroad, said Paul Edelstein, an economist at IHS Global Insight. "The past couple of months have been disappointing for the housing market recovery. After a 100 basis point jump in mortgage rates, credit demand, home sales, and new construction plans have all suffered."
Even if mortgage rates retreat as a result of the Fed's announcement Wednesday, however, they will not go back to the record lows near 3 percent earlier this year, Mr. Edelstein said.
The Fed also has to be cautious about a major change of course when "some nasty fiscal fights are brewing in Washington," he said, noting that even as the Fed was meeting, House leaders tied a measure that would fund the government for the next fiscal year to legislation defunding President Obama's health care reform.
That "sets the stage for a showdown" this fall that could be as disruptive to the financial markets and economy as the one in 2011 cited by Mr. Bernanke, Mr. Edelstein said.
"Clearly, the rise in rates, as well as fiscal retrenchment and an acrimonious environment in Washington," are fueling the Fed's hesitation, said Rick Rieder, portfolio manager at BlackRock.
Just as important is the uncertainty hanging over the future of the Fed. Mr. Bernanke is widely expected to retire from the chairmanship when his term expires in January. He declined Wednesday to say whether he is stepping down or would consider staying on if the White House asked.
The president's top choice to replace Mr. Bernanke, former White House economic adviser Lawrence H. Summers, withdrew from consideration last weekend. Fed Vice Chairman Janet Yellen now is considered the top contender, but some Fed watchers say the White House will want to consider alternatives, including keeping Mr. Bernanke in place.
Mr. Rieder said worries about the Fed chairmanship will whipsaw the markets in coming weeks.
"One of the factors that clearly has pushed both nominal and real interest rates higher in recent months has been investor concern over the changing fabric of the Fed's Federal Open Market Committee, and particularly the selection of a new chairman," he said, noting that any new chairman will have to smooth over "significant divisions" over the direction of monetary policy at a critical time when the Fed is making a major transition to tighter policies in the future.
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