Last Wednesday, the Fed announced after its Federal Open Market Committee (FOMC) meeting that it’s now forecasting just 2.2% to 2.7% GDP growth for 2012. The FOMC also forecasts an unemployment rate of 8.2% to 8.5% for 2012. Finally, the Fed provided its first-ever interest rate forecast, predicting that long-term rates will eventually rise to 4% to 5% — up substantially from current 10-year Treasury bond yields of 1.93%.
The biggest news coming out of the Fed’s unprecedented series of announcements last week was that the central banks pledged to extend its current 0% interest rate policy through at least late 2014. This shocking news is essentially an 18-month extension from the Fed’s previous guidance of low rates through mid-2013. Fed Chairman Ben Bernanke’s official reason for extending 0% short-term rates for six years (i.e., from late 2008 to late 2014) is that the U.S. economy remains “fragile.” He said the weak housing market is deterring economic growth.
Without saying so, what the Fed is really doing is protecting the banking system. Many banks have made “workout mortgages” with only 2% interest rates for homeowners who fell behind in their mortgage payments. Since banks are underwater on many of these low interest rate mortgages, the Fed can’t raise key interest rates because that would further strain the U.S. banking system’s Tier-3 (i.e., mortgage) capital.
Economists were shocked that the Fed simultaneously issued a promise of 0% short-term interest rates while predicting much higher (4% to 5%) long-term rates on the same day. In addition, the Fed threw a bucket of cold water on the U.S. economy — forecasting slow growth and high unemployment — just when we were seeing a wave of better economic news, like the latest GDP report and rising durable goods orders.
Clearly, the Fed is overwhelmed by the ongoing problems in the financial sector and the ongoing drag that housing continues to have on the banking system. The FOMC is now being run by the “doves,” who want to rescue overburdened banks while keeping the interest rate service on $15.2 trillion in federal debt as low as possible. But the good news is that the Fed’s 0% interest rate policy helps stocks, since the Fed is essentially telling investors to take their money out of banks and bonds and put it into the stock market.
Since the average stock in the S&P 500 offers a 2% dividend yield — higher (and more tax-advantaged) than most Treasury yields — stocks should continue to gain favor. When investors buy stocks, they get a higher yield than they can get in banks or Treasury bonds, and they essentially get the company for free. What a deal!