The Federal Reserve’s promise to hold borrowing costs at record lows into 2015 risks a loss of its credibility and a downward spiral in financial markets, according to the Center for Financial Stability.
Fed policy makers began a third round of debt purchases last month and said it will probably hold the federal funds rate close to zero “at least through mid-2015.” Since January, the central bank had said the rate was likely to stay low at least through late 2014.
“The Fed is essentially making a bet that its promise will in fact keep long-term rates low for that period as well,” said Lawrence Goodman, president of the CFS in New York, a research group focused on global finance and markets, in an interview. ”If rates edge higher due to factors such as inflation or credit issues, then the Fed will suffer a loss of its reputational state and that could have complications all across the yield curve. That can happen quickly and can unleash a forceful slide in the market and could thrust the economy back into recession.”
The Fed latest round of quantitative easing, known as QE, involves buying $40 billion a month of mortgage-backed securities. This will combine with the central bank’s purchases of Treasuries as part of its maturity extension program, known by traders as Operation Twist, which includes sales of short- term debt. The Fed is seeking to lower debt yields and push investors into higher-returning assets, in hopes to spur economic growth and lower unemployment.
The Standard & Poor’s 500 Index has gained 0.73 percent since the Fed’s announcement, and is up 17 percent this year. Yields on benchmark 10-year notes have declined 14 basis points to 1.62 percent since Sept. 12, the day before the conclusion of the Fed’s two-day meeting.
The FOMC also said in its policy statement on Sept. 13 that “a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens,” heightening speculation that debt purchases and low rates will prove prolonged.
Policy makers have kept their target rate for overnight loans between banks in a range of zero to 0.25 percentage point since December 2008.
The Fed’s actions have driven bond market volatility to its lowest levels since 2007, before the collapse of the subprime- mortgage market triggered the worst financial crisis since the Great Depression.
Bank of America Merrill Lynch’s MOVE Index, which measures the outlook for the pace of debt price swings based on options, is at 60.4, compared with an average of 106.43 since January 2007. The index touched 56.7 in May, just above a record low of 51.20 basis points was in May 2007.
“The Fed should now be making it resoundingly clear to financial markets that it stands ready to stabilize the size of its balance sheet and slowly and methodically reduce the monetary base so rates move to more normalized levels over time,” said Goodman, a former strangest at Bank of America Corp. and a senior fellow at the U.S. Department of Treasury. “The monetary transmission mechanism is seriously flawed. So the Fed needs to find alternatives to printing money.”