Fed, with few cards, makes unusual pledge

The Federal Reserve's highly unusual promise ? to keep interest rates low for "at least" the next two years ? comes as panicky global financial markets are looking for reassuring measures from the U.S. central bank.

Unfortunately, Fed Chairman Ben Bernanke and his colleagues have very few cards left to play.

"Effectively there are no policy levers left," Deutsche Bank chief economist Joseph LaVorgna told CNBC.

Following its regular policy-setting meeting Tuesday, the central bank announced that it expects to keep its key benchmark interest rate near zero through mid-2013, where it has fixed short-term borrowing costs since December 2008. The Fed had previously only said that it would keep short-term rates low for "an extended period."

Stock prices dropped sharply after the Fed's announcement but then bounced back with a vengeance. The Dow Jones industrial average, which had been down more than 200 points shortly after the central bank statement, ended with a gain of 430 points, or 4 percent.

Fed policymakers used significantly more downbeat language to describe current economic conditions than they had in recent months.

The Fed's rate-setting panel said the economy has grown "considerably slower" than the Fed had expected so far this year. Panelists said temporary factors, such as high energy prices and the crisis stemming from the earthquake and tsunami in Japan, only accounted for "some of the recent weakness" in economic activity.

Story: Wild day on Wall Street; Dow soars 430 points after Fed telegraphs a slow recovery

Since the Panic of 2008, the central bank has flooded the financial system with cash, spending $1.4 trillion to buy bonds backed by high-risk mortgages and snapping up another $900 billion in Treasury bonds. The Fed's easy money policy is designed to keep credit flowing after the collapse of a decade-long borrowing binge.

Despite that unprecedented intervention, the economy is barely growing, and economists see a growing chance of a second, "double dip" recession.

Fed officials have estimated that their bond buying spree may have lowered long-term interest rates by a half a percentage point. That means that if the Fed were to embark on another round of bond-buying it would have to be even bigger to have any meaningful impact, according to former Fed governor Lawrence Meyer.

"We're talking about a commitment of more than a trillion dollars, maybe closer to $2 trillion," he said. "Pushing long-term rates down by (half a) point? That's a gesture. That's nothing."

For now, the Fed will likely continue to use the relatively weak policy tools at its disposal. One is to promise to keep rates low. The Fed has already been making that promise for months, although now it has taken the unusual step of virtually setting it in stone for the next two years.

Another is to change the mix of its holdings. By selling short-term paper and buying more long-term bonds, the Fed can push long-term rates even lower. Those market-driven rates are benchmarks for a variety of consumers loans ? from mortgages to car loans.

But pushing down longer-term rates also can hurt consumers, especially retired people living on fixed incomes, because it reduces the interest rates paid on savings.

"I agree there are great limits to what the Fed can do and how effective it can be," said Meyer. "But that doesn't mean you sit on the sidelines."

Fed officials insist that have a number of policy options left ? some of them untested. Chairman Bernanke has suggested the central bank could cut the interest rate - now 0.25? percent ? that it pays banks to keep cash in reserves. It could even charge banks to stash their cash in its reserve accounts.

Story: Fed says it will hold rates fast until mid-2013

In theory, that would prompt banks to put that money to work by lending more. But corporations are already flush with cash. Bankers say they have plenty of money to lend, but demand for loans remains weak as the economy has stalled.

For now, the Fed continue to forecast a moderate pick-up in growth in the second half of the year. If that changes, and the economy slips back into recession, the central bank could turn to more aggressive measures.

"The central bank was created to be a lender of last resort," said former Fed governor Randall Krozner. "There are things that could be done, but they're not necessarily things that will be done. But it's important to make sure that people are aware that the safety net is there in case things really go off the rails. That's why you have a central bank."

Still, the Fed would be very reluctant to turn to these measures unless another major financial crisis developed.

One option would be to expand its purchases to include riskier assets like stocks. Or it could "peg" longer term rates. Much as it uses its buying and selling of short term paper to hold the overnight lending rate near zero, the Fed could use its bond-buying power to peg a longer-term rate like the five-year Treasury bond.

It could decide to lift its inflation target ? publicly tolerating a risk of losing control of prices in the name of reviving growth.

Even as the central bank is struggling to keep rates low and encourage more borrowing, the economy is being weighed down by forces outside of its control. Spending cuts at all levels of government are producing a major drag on growth.

"No wonder we haven't had this recovery: We're held back by all of this austerity," said Robert Brusca, chief economist at FAO Economics. "Why anybody talks about how austerity is the right thing to have after a recession, I don't know."

1. More on the financial crisis

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Pressure to cut government spending intensified this week following Standard and Poor's decision to downgrade the Treasury's credit rating. That downgrade threatens to make credit tighter if it reduces the value of bonds held by U.S. banks.

"There's $2 trillion worth of government-guaranteed paper inside the banking industry," said Rochdale Securities banking analyst Richard Bove. "That paper in essence loses its value if you downgrade Fannie Mae and Freddie Mac or the United States government debt. Therefore, you're reducing the capital availability to the banks because you're reducing the size of their assets."

Then there's Europe, where the banking system is still suffering the hangover from a decade-long borrowing binge. European countries remain deadlocked over the best way to repair the damage. And many analysts doubt that Europe's central bank ? which relies on those countries for funding ? has enough money to cover widespread defaults by weaker European countries. Those fears have been intensified in recent weeks as investors have demanded sharply higher rates to offset the risk of default by Italy, Europe's third largest economy.

"If Italy can't pay its debt, we're all in trouble," said Larry Kantor, head of research at Barclays Capital.

? 2011 msnbc.com Reprints

Source: http://www.msnbc.msn.com/id/44077951/ns/business-eye_on_the_economy/

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