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The drop in the Fed’s monthly bond purchases from $85 billion to $75 billion is expected to lead to higher long-term borrowing rates. Which means loan rates could tick up, though no one knows by how much.
The move could also weigh on stock markets from the United States to Asia, even though the early response from investors was surprisingly positive.
— It’s a very slight reduction. Economists had expected the Fed’s monthly purchases to be cut more than they were.
— Even though it will buy slightly fewer bonds, the Fed expects to keep its key short-term rate at a record low “well past” the time unemployment dips below 6.5 percent from today’s 7 percent. Many short-term loans will remain cheap. “They have tried to sugarcoat the pill,” says Joseph Gagnon, senior fellow at the Peterson Institute for International Economics.
— The Fed thinks the economy is finally improving consistently. An economy that can sustain its strength can withstand higher borrowing rates.
All of which suggests that while Wednesday’s action marked the beginning of the end of ultra-low interest rates, the pain may not be very severe.
The Fed’s bond purchases, begun in the fall of 2012, were meant to stimulate the economy. The purchases were designed to lower mortgage and other loan rates, lead investors to shift out of low-yielding bonds and into stocks and prod consumers and businesses to borrow and spend.
Mortgage rates have already risen in anticipation of reduced Fed bond purchases: The average on a 30-year U.S. fixed-rate mortgage has increased a full percentage point this year to 4.47 percent. Analysts say it will likely head higher now.
“Homebuyers aren’t going to be happy,” says Ellen Haberle, an economist at the online real-estate brokerage Redfin. “In the weeks ahead, mortgage rates are likely to reach or exceed 5 percent.”
Still, higher mortgage rates won’t likely reverse the recovery in the housing market. As the job market strengthens and consumers grow more confident, demand for homes could more than make up for slightly higher mortgage rates.
“It’s a better economy that gets people to buy houses,” says Greg McBride, senior financial analyst at Bankrate.com.
Likewise, an improving economy means stronger sales for businesses, even if they, too, have to pay a bit more for loans. And rates on auto, student and credit card loans are unlikely to change much. They’re tied more to the short-term rates the Fed is leaving alone.
Savers have suffered from the Fed’s low-interest rate policy. Wednesday’s move could offer some relief to people who keep money in three- and four-year CDs. But it probably won’t mean a big jump from, say, the average 0.48 percent rate on 3-year CDs.
“They’re starting from such a low point, it’s not going to be nearly enough to make three- and four-year CDs anywhere near compelling,” McBride says.
By keeping short-term rates near zero, the Fed move does nothing for people with money in savings accounts and very short-term CDs.
Banks earn money from the difference between the short-term rates they pay depositors and the longer-term rates they charge consumers and businesses. The gap reached a five-year low in the middle of this year. But it’s likely to widen as longer-term rates rise and short-term rates stay fixed. Bank profits should rise as a result.
Banks will also benefit if an improving economy leads more credit-worthy businesses and consumers to seek loans.
The Fed intended its bond purchases, in part, to push bond yields so low that investors would move money into stocks, thereby driving up share prices. Since mid-November 2012, the Dow Jones industrial average has surged 28 percent.
Many Wall Street analysts feared stocks would plummet once the Fed announced a pullback in its bond buying. On Wednesday, the opposite occurred: The Dow rocketed 293 points. Investors appeared to focus more on the good news (the economy is improving) than the bad (the easy-money days may be ending).
“As the tapering continues, there will be less liquidity going into the stock market,” and the rally will either slow or end entirely, says Sung Won Sohn, an economics professor at the Martin Smith School of Business at California State University.
Over the past year, the super-low U.S. rates had led investors to seek higher-yielding investments in emerging markets. Last summer and fall, speculation about a slowdown in the Fed’s stimulus sent stocks tumbling in the developing world.
Indonesia’s market has sunk nearly 19 percent since investors began anticipating the Fed move in May. Stocks in Thailand are down 18 percent. Without Fed policy driving cash into developing markets, these stock markets might have further to fall.
Mark Olson, a former Fed governor, says the central bank succeeded in convincing investors that a slight pullback in bond purchases is hardly the same as tightening interest-rate policy.
The stimulus continues — through record-low short-term rates and the continuing, though reduced, bond purchases.
“And for once,” Olson says, “I think the markets read it the way the Fed had hoped.”
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