Fed ties stimulus to jobs, inflation in unprecedented steps to bolster economy

December 12, 2012

The Federal Reserve will take steps to bolster the economy until the unemployment rate falls to 6.5 percent or inflation looks likely to exceed 2.5 percent, the central bank said Wednesday in a historic move that for the first time specifies the Fed’s goals for the nation’s economy.

The Fed also said it would buy $45 billion in Treasury bonds a month, on top of $40 billon a month it is already buying in mortgage bonds, in an effort to flood markets with money and reduce interest rates on a wide range of loans. Lower interest rates tend to stimulate borrowing, economic activity and employment.

The actions signaled the Fed’s concerns that high unemployment — what Fed Chairman Ben S. Bernanke called “an enormous waste of human and economic potential” — will cast a long shadow over the nation for years. Fed officials projected that the jobless rate, now at 7.7 percent, would not reach 6.5 percent until near the end of 2015 at the earliest.

The economy faces a possible recession if Congress and the White House fail to avert the “fiscal cliff,” an automatic series of deep spending cuts and tax increases for nearly all Americans set to take effect at the end of the year.

Negotiations appeared to be at an impasse this week, and some in both political parties have said that allowing the budget cuts and tax hikes to kick in for a short while might be acceptable. But Bernanke used stern language Wednesday to warn against such thinking, adding that while the Fed might take action to stem the damage, its powers would be limited.

In an unprecendent move, Federal Reserve Chairman Ben Bernanke announced Wednesday that the Fed will continue to try and boost the economy until unemployment numbers hit 6.5 percent or the inflation rate reaches 2.5 percent. (The Fold/The Washington Post)

“If the economy actually went off the fiscal cliff . . . that would have very significant adverse effects on the economy and on the unemployment rate,” Bernanke said at a news conference. “We would try to do what we could . . . but I just want to again be clear that we cannot offset the full impact of the fiscal cliff. It’s just too big.”

Bernanke added that the risk of going over the fiscal cliff — a term he coined — is already cutting into customer spending and business investment. “The most helpful thing that Congress and [the] administration can do at this point,” he said, “ . . . is to find a solution and avoid derailing the recovery.”

Policies’ effect

It was not clear whether the Fed’s actions, following a two-day meeting, would have an immediate effect on the economy. The Fed had already said it planned to take continuous action to boost the recovery until at least mid-2015. The reaction of financial markets Wednesday was muted. Stock markets ended the day flat.

Bernanke faces a bit of a conundrum. While he speaks gravely of the ill effects of prolonged high unemployment, his ability to take steps to reduce joblessness are constrained. He has to find consensus on the Fed’s governing committee, where many members are nervous about overheating the economy, causing bubbles or inflation.

And Fed policies work in indirect ways. If the Fed’s actions to keep interest rates low, for example, bring down mortgage costs further, it may lead more people to buy homes, which could create construction jobs. But there are many other factors at play. Banks could choose to charge higher rates and make more profit, for example. Or global trade could continue to decline, further weakening the job market.

“If we could wave a magic wand and get unemployment down to 5 percent tomorrow, obviously we would do that,” Bernanke said. “But there are constraints in terms of the dynamics of the economy, in terms of the power of these tools and in terms of the fact that we do need to take into account, you know, the possibility of other costs and risks that might be associated with a large expansion of our [policies.]”

Many analysts saw the Fed’s decision to institute specific economic targets as the most important development of the day.

Those targets make clear that the Fed will continue to intervene in support of economic growth until significant improvement is made toward reducing joblessness, or until inflation expectations, as measured by betting in financial markets, meaningfully pick up. (There’s little hint that inflation will exceed the Fed’s long-term target of 2 percent anytime soon.)

According to leading economic thinking, the Fed’s policies should give businesses and consumers the confidence to borrow and spend money, fueling economic activity.

The Fed’s policy is “particularly likely to help stimulate the economy” and “reduce some of the considerable uncertainty about Fed policy that has resulted from the series of unprecedented actions taken over the past few years,” said Michael Woodford, a Columbia University professor and one of the nation’s leading scholars of central-bank policymaking.

The purchases of Treasury and mortgage bonds are more of a continuation of existing policy than an intensification.

The Fed had already been buying $45 billion in Treasury bonds and $40 billion in mortgage bonds per month. But the Treasury purchases were set to end this month, and that could have sent a confusing message to the markets at a time when the Fed wanted to signal that it was promoting growth. So the Fed is continuing the purchases.

The actions followed significant new commitments made earlier in the fall, when the Fed said it would seek to bolster the economy even after the recovery began to strengthen.

The Fed’s transformation

In embracing specific economic targets for unemployment and inflation, the Fed is reflecting a transformation in how it has approached its job under Bernanke.

Traditionally, the central bank has offered very little public information about how it planned to intervene in the market. Since taking the helm, Bernanke has pushed officials to allow the central bank to be more open.

The Fed’s policy statement Wednesday said it had seen moderate economic growth since its last meeting in October but warned that it “remains concerned that . . . economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook.”

The central bank also released economic projections. The Fed expects the unemployment rate at the end of next year to be between 7.3 percent and 7.7 percent.

One member of the Fed, Jeffrey M. Lacker, the president of the Federal Reserve Bank of Richmond, dissented, saying he disagreed with the decision to purchase bonds and the characterization of the conditions under which it would be appropriate to keep interest rates ultra-low.

The Fed will meet again late next month.

Zachary A. Goldfarb is a staff writer covering the White House, focusing on President Obama’s economic, financial and fiscal policy.
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