News & Events

Fed Expected to Rachet Back on Economic Stimulus Efforts

The Federal Reserve is expected to announce the first reduction in the economic stimulus efforts it began five years ago early this afternoon.

The unprecedented measures, which include a prolonged period of low interest rates and about $85 billion in monthly bond purchases, were undertaken in response to the global economic crisis that peaked in 2008. Ratcheting them back could mean higher borrowing costs for businesses and municipalities, and higher mortgage rates for consumers.

University of Iowa Finance Professor Artem Durnev said the expected Fed action may also shift 1 percent to 2 percent of the money now invested in the stock market back to the bond market. That may damp the recent stock price gains experienced by many publicly traded companies, such as Iowa-based Principal Financial Group and American Equity, he said.

The Fed has been racing the clock to stabilize the U.S. economy so it can begin deflating the global bubble its domestic stimulus efforts have created for holders of the dollar, which is the world’s foremost currency, according to Durnev. The Fed is expected to announce the first step in a gradual reduction in its monthly bond purchases, which most economists estimate will fall by about $10 to $15 billion, and lay out a timetable for further reductions.

The federal funds target rate, which serves as the nation’s benchmark lending rate, has been pinned at a historic low of zero to 25 basis points since December of 2008. There are 100 basis points in a single percentage point. With no way to further lower the fed fund target rates, the central bank began its monthly bond purchases, according to Durney.

Bonds are used by large corporations and government entities to borrow money. Instead of going to a bank for a loan as consumers do, they sell bonds to investors at a promised rate of return. That rate represents the borrowing costs the bond issuers will pay to investors.

The Fed’s bond purchases created artificial demand in the bond market, which allowed bond issuers to offer less to the investors buying them, thereby reducing their own borrowing costs. Many of the nation’s interest rates, including mortgage rates, are also tied to returns on the 10-year Treasury note, which allowed the Fed to use them to reduce homeowner borrowing costs.

The lower bond returns also prompted some investors to shift funds into the stock market.

Many economists expect the cut in Fed bond buying to come entirely from the $45 billion a month it’s been spending on Treasury bond purchases. They expect it to continue to spend $40 billion a month on mortgage bond purchases, which have also helped keep mortgage rates low and stimulate the U.S. housing market.

The big wildcard is how a reduction in bond purchases will be viewed by the stock market. The elimination of uncertainty about the future is a positive for markets, according to Durnev, but whether or not it will be enough to offset the shifting of some funds back to the bond market is unknown. Stock market trading volume has been muted ahead of the Fed announcement.

The first details from the Fed will begin to be released to the public at 1 p.m. Des Moines time, when the FOMC statement and economic projections will be posted online at www.federalreserve.gov/newsevents/default.htm. Fed Chairman Ben Bernanke is expected to provide additional details at a press conference at 1:30 p..m., which can be viewed online at www.ustream.tv/federalreserve.


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