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Fed Study Says Its Plan Is Working

Friday, 23 Sep 2011 | 4:30 PM ET
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A new study by the Federal Reserve Bank of Clevelandfindsthe Fed's addition of language indicating short-term interest rates would remain near zero until the middle of 2013 pushed down interest rate expectations across a broad spectrum of credit classes.

The Fed announced after the August FOMC meeting of its policy-making committee that it believed conditions would warrant holding short-term interest rates near zero until the middle of 2013. The idea behind putting that promise of short-term rates into the FOMC statement was that it could lower interest rates by altering expectations. The Cleveland study seems to confirm this idea was right.

From the study:

This was a unique move in the realm of FOMC policy changes, partly because it was only operational through the language in the Committee’s statement, and partly because of the reference to a specific date. The FOMC made a similar move when it added the “extended period” language in March 2009. By making a tentative commitment to not raise interest rates until the middle of 2013, the Committee was attempting to alter the expectations of market participants. It worked. Since the announcement, forecasts for a variety of interest rates have fallen, at least in part due to the lower expectations for future interest rates.

Unfortunately, it's not clear the greater goal of Fed policy is working. After all, lower interest rates is not the goal of Fed policy. Interest rates are supposed to be a tool for achieving the goal on maximum employment in the context of price stability.

So are lower interest rates raising employment levels? It's actually possible the Fed's statement is backfiring in terms of achieving growth. The warning that economic conditions would warrant low interest rates for two more years may very well have made a lot of businesses decide to hunker down, slow expansion and avoid hiring. If the Fed is saying things are bad enough that it needs to hang onto the zero bound for another two years, do you really want to undertake a risky business expansion?

This kind of hunkering down would certainly explain the fall in interest rates, as saving grows and the demand for credit withers.

Even home buying could be delayed by the new language. If you know interest rates are staying low now and economic times are going to get tougher, why not wait to buy a home until a year or two from now?

The attempt to lower interest rates by changing market expectations could be a disguised contractionary monetary policy.

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