Federal Reserve expects slower growth for rest of 2013

Posted Friday, Aug. 30, 2013  comments  Print Reprints
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The Federal Reserve might begin tapering off its economic life support late this year and finish a controversial program of bond purchases by the middle of the next year, Chairman Ben Bernanke said Wednesday in remarks that triggered fear and loathing in financial markets.

Stocks fell sharply after Bernanke used a midafternoon news conference to clarify the circumstances under which he’d begin easing off the pace of purchases of government and mortgage bonds, a pace that’s now averaging $85 billion a month.

Since Bernanke first hinted about tapering off the purchases in May, stocks have been volatile and bond yields _ what the government has to pay investors that buy its bonds _ shot up. Before taking questions Wednesday, Bernanke sought to calm the markets with a detailed explanation of the conditions under which the Fed’s tapering or purchases might begin.

It didn’t work. The Dow Jones industrial average plunged 206.04 points to finish at 15,112.19. The S&P 500 fell 22.88 points to end at 1,628.93, and the tech-heavy NASDAQ dipped 38.98 points to close at 3,443.20. The yield on the 10-year Treasury bond quickly jumped up to 2.34 percent from 2.31 percent, the highest since March 2012.

The market reaction is a sign of today’s unique times. Bernanke’s Fed is considering pulling back on the bond purchases, which are designed to stimulate economic activity, because several important economic data points show marked improvement. A stronger economic outlook usually would be bullish for financial markets, but having received the benefit of the Fed’s stimulus for more than two years, investors are fretting about life without it.

In fact, the Fed issued revised economic projections Wednesday that show improvement in the unemployment rate but slightly downgraded estimates this year on the gross domestic product, the sum of all the country’s goods and services.

The bond purchases are known as quantitative easing, shorthanded as QE3 because they’re in their third iteration. The idea is to drive down the return on investment in government bonds so that investors seek greater returns elsewhere, generating economic activity and wealth that benefits the broader economy.

While Bernanke said an improving economy might permit tapering off, he cautioned that any slowdown might put those plans on ice.

“We gave no deterministic or fixed plan,” the Fed chief said.

Adding to the sour sentiment on Wall Street, the Fed’s rate-setting Open Market Committee muddied the waters with its statement at the close of its two-day meeting. The committee left its benchmark lending rate where it’s been since December 2008, and it noted that “the housing sector has strengthened further, but fiscal policy is restraining economic growth.” The committee also noted that labor market conditions have improved, “but the unemployment rate remains elevated.”

This good news-bad news statement extended to the vote, with Federal Reserve Bank of Kansas City President Esther George preferring to raise the rate on concerns that the Fed’s bond purchases might eventually spark high inflation.

James Bullard, the president of the Federal Reserve Bank of St. Louis, voted against holding the rate steady because he thought the Fed should signal more strongly its willingness to combat a persistently low inflation rate.

In other words, one voting member of the committee thought inflation is a threat, while another worried that deflation – the decline in prices across the economy – is a bigger threat than has been acknowledged.

It underscored how removal of the unconventional policy tool represents uncharted waters. Equally unusual is the fact that bond yields are rising while inflation remains subdued, below the Fed’s target rate of near 2 percent. Usually yields rise in response to inflation because nervous investors demand higher returns to ensure that their investments earn more than the rate of inflation. But there’s no sign of any looming inflation threat.

“This is an economy with a whole lot of slack in it. The difference between GDP and potential GDP is pretty big. The unemployment rate is too high. . . . It’s hard to find a good scare story about inflation,” said David Blitzer, the managing director of S&P Dow Jones Indices.

Since mortgage rates take a cue from the yield on 10-year government bonds, homeowners now are finding it more expensive to refinance mortgages or take out new ones. Bernanke acknowledged this, but he said the effect would be “not all that dramatic” on homebuyers’ monthly payments.

Over the life of a 15-year or 30-year loan, however, homeowners pay banks considerably more than they otherwise would have.

CORRECTION: An earlier version of this story had a typographic error in a quote from Federal Reserve Chairman Ben Bernanke. He said, "We have no deterministic or fixed plan,” not "We gave no deterministic or fixed plan.”

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