Fed to Hold Rates Low Until 2013, Sees Increased Risks to Economy

Volatile stock markets soared Tuesday after the Federal Reserve said in unusually clear language that exceptionally low interest rates will stay in place at least through mid-2013.

The Fed also strengthened and clarified the language it used to describe the economic slowdown that has kept U.S. unemployment stubbornly high and contributed to a massive stock market selloff in recent weeks.

Investors were initially disappointed that the Federal Open Market Committee declined to offer new stimulus programs and stocks fell briefly into negative territory. But markets abruptly changed direction and the Dow Jones Industrial average roared higher, closing up 430 points.

Fed language, often vague under previous chairmen, sought to clarify the decision to maintain the current loose fiscal policy. So instead of using the open-ended extended period phrase for when the Fed might shift course, Fed policy makers offered a far more specific timetable for when they might start tightening monetary policy by raising interest rates and shedding some of its massive portfolio.

The committee currently anticipates that economic conditions -- including low rates of resource utilization and a subdued outlook for inflation over the medium run -- are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013," the central bank said in a statement.

Three members of the 10-person committee -- Richard Fisher of the Dallas Fed, Narayana Kocherlakota of Minneapolis and Charles Plosser of Philadelphia -- dissented with the decision, an unusually large number.

U.S. stock markets had bounced back in early trading following Mondays 635 point rout of the Dow. The sentiment among traders leaned toward optimism that the Fed would announce some form of new stimulus.

That didnt happen. But Fed policy makers made it clear that nothing is off the table if the economy continues to stumble.

As markets have swooned in recent weeks, there has been growing criticism of fiscal policy makers both in the U.S. and in Europe. Congressional Republicans and Democrats bickered for weeks as a potentially devastating default loomed over the U.S. government. In Europe, the debt crisis has spread to the much larger economies of Italy and Spain and European leaders seem helpless to control the contagion.

We just dont have leadership right now, said Bernard Kiely, a financial planner at Kiely Capital Management in Morristown, N.J.

Kiely was hoping for further easing of monetary policy in the form of a new round of quantitative easing. In lieu of that, Kiely sought language from the Fed that would boost investor confidence something, anything to indicate that the Fed has a plan and is ready to implement it if necessary.

Theres only so much the Fed can do, but right now the market is operating simply on emotions, he said. Consequently, a strong statement from the Fed would likely have a significant impact on investor sentiment.

Investors were briefly spooked by the Feds increasingly pessimistic view of the economy, then cheered by its candor.

As expected the FOMC statement noted that the global economic malaise has been much more difficult to eradicate than many had forecasted. The pervasive fear is that the Fed has run out of weapons to fight the malaise.

The Fed did little Tuesday to alter that perception.

Many analysts correctly predicted the Fed would use stronger language Tuesday to get its point across, while foregoing temporarily, at least -- dramatic new action.

In June, as one economic report after another signaled that the economy was weakening rather than recovering, the Fed said its key overnight lending rate would remain exceptionally low for an extended period.

Earlier in the year, Fed Chairman Ben Bernanke had suggested the Fed might tighten fiscal policy by the end of the year or early in 2012 if the economy showed signs of significant strength. But unemployment has remained stubbornly high at more than 9% and the housing market is still searching for a bottom.

In addition to the downgrade of U.S. debt by rating firm Standard & Poors late Friday, global markets have also been digesting the spread of Europes debt crisis to Spain and Italy and fears of another global recession.

The Feds arsenal still includes a possible third round of quantitative easing, the already dubbed QE3. Optimism for such a program helped push the Dow more than 200 points higher on Tuesday.

But interest rates cant go much lower. The key overnight rate has held steady at 0% to 0.25% since December of 2008, cut to that range during the worst of the financial crisis. Moreover, there is strong sentiment that the trillions of dollars of securities purchased under QE1 and QE2 did little to spark the economy and could eventually lead to harmful inflation.

Kiely conceded that the first two asset purchasing programs did little to stimulate the economy, but he supports a third if only as a means of boosting investor confidence.

The Fed is undoubtedly aware that there will be a strong political backlash to another expensive round of quantitative easing.

Many analysts share the sentiments of Peter Boockvar, equity strategist at Miller Tabak, who wrote in a note ahead of the Fed announcement: We've now seen the wreckage that followed after [QE2] ended on June 30th, the entire QE2 equity rally has almost reversed. Here lies the fallacy with any short-term stimulus, either monetary or fiscal. At some point it has to end and then we revert back to where we were, with then a bill to pay either through higher taxes or from the eventual exit of policy.