Fed's interest-rate move wows Dow, but is also sign of plodding recovery

In a sign the US economy faces stiff headwinds for at least the next two years, the Federal Reserve’s Open Market Committee, which sets short-term interest-rate policy, said Tuesday that it expects to maintain exceptionally low interest rates through the middle of 2013.

Never in recent history has the Fed specified how long it intends to keep rates low. Apparently, Wall Street received the news with enthusiasm – the Dow Jones Industrial Average soared 429.92 points Tuesday, after dropping 634 points on Monday.

However, the Fed's announcement was accompanied by a somewhat dark assessment of the economy, which it describes as “slower than expected” and as having greater “downside risks” in the future.

The announcement is something of a two-edged sword. With short-term interest rates virtually guaranteed to remain close to zero for two years, companies know they don't need to worry anytime soon about the costs of borrowing. But the Fed, which has a mandate to keep the economy growing, is also sending a message to the unemployed: Don’t expect much improvement in the near future. And the Fed’s economic outlook means President Obama will be running for reelection during a time of very slow economic growth.

“The Fed is being honest about the economy,” says Eric Stein, a vice president at Eaton Vance, investment managers in Boston. “It is saying there is not much more it can be doing; it will take time and smart policy changes that focus on long-run competitiveness to turn the economy around.”

The Fed’s statement resulted in sharp volatility in the stock market. Immediately after the announcement at 2:15 p.m. EDT, the stock market dropped sharply, moving from the plus column to a loss of about 150 points on the Dow average. But by the close, the Dow not only had recovered, but had gained 429.62.points. The uptick marks a major turnaround from the 634-point loss on Monday, the first day of trading after Standard & Poor’s downgraded the credit rating of the United States from AAA to AA+.

“Maybe the [stock] buyers think the Fed not raising interest rates anytime soon is a vote of confidence in the market,” says Phil Flynn, senior market analyst at PFG Best, a brokerage house, in Chicago. “They must like the fact the Fed says it will not raise interest rates anytime soon.”

Another factor helping the market was a major rally in the bond market, where the yield on the 10-year Treasury dropped to 2 percent, its lowest rate since the financial crisis of 2008.

Although the stock market soared, the Fed’s description of the economy was sobering, at best. The central bank said it has seen deterioration in the labor market in recent months, and it noted that consumer spending has flattened and the housing sector remains weak. The only positive sign the central bank cited was continued business spending on equipment and software.

Last month, the Fed blamed outside events, such as the tsunami and earthquake in Japan and floods in the Midwest, for economic weakness. Now it says such “temporary factors” account for only part of the economic weakness.

In its earlier economic assessments, the Fed had anticipated that the economy would pick up to about a 3.5 percent growth rate in the second half of 2011. Now the Fed is not so sure. It concluded, “downside risks to the economic outlook have increased.”

Even before the Fed’s announcement, Federal Reserve watchers assumed that the Fed would set the stage for another round of monetary stimulus. The yields on long-term Treasury bills had dropped in expectation of some future Fed action, says Doug Roberts of Channel Capital Research in Shrewsbury, N.J.

After Tuesday's announcement, Mr. Roberts said the fact that the Fed did not set the stage for another round of monetary easing was “very disappointing.”

At the end of June, the Fed ended a program called Quantitative Easing 2, to buy long-term government and agency securities in an effort to stimulate the economy. Some had hoped the Fed would initiate a QE3 program.

In its statement, the Fed said merely that it discussed the range of policy tools to promote stronger growth with low inflation in the future. “It will continue to assess the economic outlook in light of the incoming information and is prepared to employ these tools as appropriate,” it said.

The Fed’s actions were not unanimous. Three regional bank presidents voted against setting an actual date for how long interest rates would remain low.