Two-Year Extension of Fed's Low Interest Rates Will Deliver Damaging Inflation

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With little ammo left in its arsenal, the Federal Open Market Committee (FOMC) yesterday (Tuesday) was unable to offer jittery markets anything more than a two-year extension of the Fed's low interest rates.

Instead of promising to keep rates at their low 0% to 0.25% level for an "extended period" as it has in its past several meetings, the FOMC said it would maintain those rates "at least through mid-2013."

However, Money Morning Contributing Editor Martin Hutchinson thinks that even this minimal action will do more harm than good.

"This is worse than QE3," Hutchinson said, referring to the potential for a third round of quantitative easing, in which the Fed has pumped trillions of dollars into the economy by purchasing Treasury bonds.

"What makes the Fed think it can forecast conditions two years in the future?" Hutchinson continued. "It has already been surprised on both growth and inflation just this year, since its January forecasts, which forecast 2011 growth of 3.4% to 3.9% and inflation of 1.3 to 1.7%. It's notable that three of the five regional Fed presidents – the guys actually in touch with the market – voted against."

Hutchinson has warned repeatedly that the Fed's policies have not only failed to jumpstart the economy, but have spurred inflation and helped keep unemployment high.

"This action has greatly increased the chances of the U.S. economy experiencing hyperinflation, on top of its other woes," Hutchinson said. "It does nothing for growth, the current problem."

If U.S. Federal Reserve Chairman Ben S. Bernanke's intention was to reassure the markets, it didn't work. The markets, which had rallied as much as 2% earlier in the day, swung wildly after the FOMC statement was released at 2:15 p.m. Eastern Daylight Time.

At one point, the Dow Jones Industrial Average was down 150 points and the Standard and Poor's 500 Index down more than 1%, though both bounced back as the afternoon wore on.

"The market needs a sense that the Fed is willing to do more today, rather than merely say that they're not going to tighten in mid-2012 versus 2013," Senior Economist Cary Leahey of Decision Economics Inc., told Reuters.

The recent stock market plunge – the S&P 500 index fell 11% in the three days ending with Monday's disastrous session – coupled with a barrage of reports pointing to an economy in danger of slipping back into recession, put tremendous pressure on the Fed to take some kind of action to reassure investors.

Wall Street clearly was expecting more, but the Fed had few options in delivering any sort of policy change that could make an impact. It has already done about as much as it can do; the Fed's interest rates are near zero, and the central bank has injected $2.9 trillion into the economy with its quantitative easing programs (QE1 and QE2).

The Fed's ineffectiveness in reviving the economy has raised questions over whether monetary policy is the right medicine.

"I don't think you have a money problem right now," Jerry Webman, chief economist for OppenheimerFunds, told Marketwatch. "Monetary policy is about controlling the supply and price of money, and right now there's ample supply, and money can be had at a very cheap price."

Donald Kohn, a fellow at the Brookings Institution and former Fed vice chairman, told The New York Times that while the Fed can keep injecting trillions into the economy, it can't control what people do with it: "I think the major problem here is that people don't want to spend, and that's about confidence in the economy and the government."

The FOMC at least acknowledged that things have gotten worse since its last meeting in June.

"Economic growth so far this year has been considerably slower than the Committee had expected," the FOMC said, noting the high unemployment, flat consumer spending and the weak housing market.

Unfortunately, the two-year extension of the Fed's low interest rates – which have remained near zero since December 2008 – probably won't do anything for the economy and could even be seen as an admission that things won't improve for a long time.

"The statement was extremely negative in its outlook on the economy," Omar Eisner, chief market analyst for the Commonwealth Foreign Exchange, told Reuters. "By pegging the extraordinarily low interest rates to a date in the distant future, the Fed has essentially said that they see the current level of weakness lasting far longer than previously expected. This is definitely a negative for risk appetite."

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  1. Robert Rennaker | August 10, 2011

    I don't understand why the FED is helping only the financial giants. Low interday interest costs are supposed to encourage lending at higher rates, but nobody is borrowing, and no loans are being approved.

    Can you help me make sense of this situation?

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