Fed keeps rate near zero but sees brighter economy in 2021

Federal Reserve Chairman Jerome Powell. PHOTO CREDIT: Greg Nash

WASHINGTON — The Federal Reserve said today that it will keep buying government bonds until the economy makes “substantial” progress, a step intended to reassure financial markets and keep long-term borrowing rates low.

The Fed also said after its latest policy meeting that it will keep its short-term benchmark interest rate pegged near zero. The Fed has kept its key rate there since March, when it took a range of extraordinary steps to fight the pandemic recession by keeping credit flowing.

In a series of economic projections, Fed officials painted a brighter picture of the economy next year, compared with its last projections in September. The improvement likely reflects the expected impact of the new coronavirus vaccines. The Fed now expects the unemployment rate will fall from the current 6.7% to 5% by the end of 2021.

The Fed’s announcement coincides with an economy that is stumbling and might even shrink over the winter as the raging pandemic forces new business restrictions and keeps many consumers at home. Weighing the bleak short-term outlook and the brighter long-term picture has complicated the Fed’s policymaking as it assesses how much more stimulus to pursue.

With its benchmark rate already near zero, the Fed has turned to bond purchases, buying $80 billion of Treasury securities and $40 billion of mortgage-backed bonds a month. Those moves indirectly lower rates on mortgages, auto loans and credit cards, with the aim of encouraging more borrowing and spending.

Chair Jerome Powell and many other Fed officials have repeatedly urged Congress to approve more economic aid to carry the economy through what’s expected to be a financially painful winter, with cold weather foreclosing outdoor dining and rising virus cases discouraging many Americans from shopping in stores, going to gyms or traveling.

Congressional leaders are considering a $748 billion relief package that would provide extended unemployment benefits, more loans for small businesses and possibly another round of stimulus checks for individual Americans.

Recent economic reports have generally reflected a sharply slowing recovery. On Wednesday, the Commerce Department reported the sharpest drop in retail sales in seven months. Americans held back on spending in November at the start of the holiday shopping season, which typically accounts for a quarter or more of retailers’ annual sales.

Sales tumbled across the board — from clothing, electronic and furniture stores to department stores and restaurants. The only two bright spots were online and grocery store sales.

The retail sales report was the latest evidence that the pandemic is slowing the U.S. economy as businesses grapple with tighter restrictions and millions of consumers stay away from stores.

Last week, the number of people seeking unemployment aid rose for the third time in four weeks, evidence that companies are increasingly cutting jobs nine months since the erupted of the pandemic caused a deep recession.

The Fed’s new guidance on bond purchases marks a shift from its previous statements, when it said it would simply keep buying bonds “over the coming months.”

But providing a more specific timeline ensures that financial markets will not anticipate an earlier reduction in the purchases that could cause investors to push up rates earlier than the Fed wants. Longer-term rates reflect investor expectations for future borrowing costs. So reducing expected future rates keeps current rates lower.

“It’s helpful to be as clear as you can be about your intentions,” said Bill English, a former Fed official who teaches finance at the Yale School of Management.

Some economists had expected the Fed to announce a shift in its bond purchases by buying more longer-term bonds and fewer shorter-term securities — a step they could still take in future meetings.

Such a move would seek to deliver more immediate help for consumers and businesses. Buying more 10-year Treasurys, for example, lowers their yield, and the 10-year yield influences mortgage rates and other borrowing costs. Yields on two- or three-year bonds, by contrast, don’t affect many other rates.

But the Fed may prefer to keep that step in reserve in the event the economy significantly worsens next year. Or, it may also see it as a more effective move when the economy is reopening and people and businesses want to borrow more and expand.

That’s likely to send rates up, and the Fed may want to buy more longer-term bonds at that time to keep such increases in check.

“It’s more useful when you have the reopening under way,” said James Knightley, chief international economist for ING, a global bank. “It will be much more effective next year.”

The Fed’s bond purchases soaked up about half the new debt the government issued this year, according to Oxford Economics. If the program continues at its current pace, the central bank will own about one-quarter of all outstanding federal government bonds by the end of next year, Oxford calculates.

Those purchases have swollen the Fed’s balance sheet by more than $3 trillion since the pandemic began, to $7.2 trillion, by far a record high. While enormous, that is about one-third the size of the U.S. economy, a lower proportion than in some other nations, such as Japan.

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