The Federal Reserve's unprecedented decision Wednesday to tie an eventual increase in a key short-term interest rate to unemployment and inflation targets could push up rates sooner than the Fed intends. But economists say the rewards outweigh the risks.
The Fed also said it would continue buying government bonds to keep long-term interest rates low and bolster the recovery. That was widely anticipated.
Fed policymakers surprised markets by agreeing to keep its benchmark short-term rate near zero at least until the unemployment rate, now 7.7%, falls to 6.5% and inflation is forecast to reach an annual 2.5% rate. The Fed had been saying short-term rates likely would remain very low until at least mid-2015. As the Fed's latest forecast calls for the jobless rate to fall to 6% to 6.6% by the end of 2015, its projection effectively hasn't changed.
Still, Fed Chairman Ben Bernanke said thresholds based on economic conditions provide clearer guidance to financial markets about future Fed policy than target dates do. Rather than waiting for the Fed to revise the projected date for interest rate hikes, investors can adjust expectations based on the state of the economy.
Bernanke cautioned that 6.5% unemployment and 2.5% inflation would not automatically trigger a rate increase but would simply set minimum thresholds for when the Fed could consider raising rates. He said policymakers also would weigh other data, such as whether unemployment is falling because more Americans are dropping out of the labor force, rather than job growth.
"It by no means puts monetary policy on autopilot," he said.
Economist Paul Ashworth says the thresholds should let investors gradually push up interest rates in anticipation of a Fed rate increase as economic conditions improve. Previously, an abrupt change in the Fed's projected date for a rate increase could have disrupted markets, Ashworth says.
The new policy runs the risk that investors will place more emphasis than warranted on dramatic declines in the jobless rate, possibly leading to increases in interest rates sooner than intended. But, Ashworth adds, Fed officials can clarify their plans through speeches and testimony.
The Fed also said it will continue monthly purchases of $45 billion in long-term Treasury bonds. It's been selling a like amount of short-term Treasuries to keep its holdings stable, but that program ends this month.
The Fed said it will keep buying $40 billion a month in mortgage-backed securities to contain mortgage rates.
The purchases will continue until the job market improves "substantially." They're intended to cut borrowing costs for consumers and businesses, but economists say their effect is limited by tight credit.
Fed policymakers also slightly tempered their outlook, and now expect growth of 2.3% to 3% next year.
(c) Copyright 2012 USA TODAY, a division of Gannett Co. Inc.
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