On December 12, the U.S. Federal Reserve came out with its latest round of policy prescriptions for the sluggish U.S. economy. The Fed made two important shifts in its latest announcement:
- In addition to purchasing $40 billion of mortgage-backed securities per month as part of its "quantitative easing" policy, it will also purchase $45 billion in U.S. Treasuries. This new purchase program takes the place of the policy known as "Operation Twist."
- The Fed will keep short-term rates near zero as long as unemployment stays above 6.5% and inflation holds below 2.5%. The Fed previously said it wouldn't boost rates until 2015, but it now projects that unemployment won't drop to its 6.5% target until 2015 - making the end result essentially the same.
In effect, these actions amount to the Federal Reserve telling the world that it will continue to stimulate the economy until the unemployment rate falls to a more acceptable level than its current 7.7%. This policy is a plus for the economy and those that find jobs as a result of the stimulus - assuming that quantitative easing indeed has the impact that the Fed believes it does. Unfortunately, it comes with a price: savers who need to hold their cash in low-risk investments will continue to see yields near or below the rate of inflation. Investors may therefore question, fairly, whether the Fed's prescription is doing as much harm as it is good.
This new approach is likely to have another unintended effect: increased bond market volatility. Whereas before investors could take comfort that rates will stay near zero until 2015, now a stronger economy has the potential to frighten the markets since it raises the likelihood that rates will go up sooner than expected. As a result, the already-challenging bond market outlook for 2013 has a new wrinkle: added volatility surrounding economic data releases such as the monthly jobs report.
In short, this move marks another dramatic shift regarding Fed policy. Unfortunately for investors, the message is clear: keep buying risky assets, or take the chance that your returns won't keep up with inflation.