Investors have grown nervous that the Federal Reserve will scale back its efforts to boost the U.S. economy sooner than many expected.
Yet almost lost in the anxiety that gripped the stock market this week is that whenever the Fed slows its drive to keep interest rates low, it will be cause for celebration: It will mean policymakers think the economy is strong enough to accelerate with less help from the Fed.
“We should be wishing for higher interest rates,” says Kevin Logan, HSBC’s chief U.S. economist. “It would be a sign of a more healthy economy.”
Over the past five years, the Fed has acted aggressively to try to boost the economy. Among other steps, it cut short-term interest rates to record lows and said it planned to keep them there at least until unemployment falls to 6.5 percent (from 7.5 percent in April).
And in September, it began a third round of bond purchases — $85 billion a month. The goal has been to drive down long-term loan rates and encourage more borrowing, spending and hiring.
The lower rates have fueled a surge in stock prices: The Dow Jones Industrial Average has jumped about 17 percent this year and set a record high. Even so, investors have grown jittery about the Fed’s likely timetable for starting to curtail its bond purchases.
Speculation intensified Wednesday after the Fed released a summary of the April 30-May 1 meeting of its policy committee. The minutes said “a number of participants” were open to reducing the Fed’s bond purchases as soon as its next meeting June 18-19 — if the economy is showing strong and sustained growth.
The news caused stocks to gyrate Wednesday, and the Dow finished down 80 points. On Thursday, investors appeared calmer, but stocks still closed down slightly.
The Fed faces a perilous decision: If it pulls back its stimulus too soon, the U.S. economic recovery could sputter. If it waits too long, super-low rates could ignite inflation. Or they could swell speculative asset bubbles as investors pursue riskier investments with potentially richer returns than low-yielding bonds.
The Fed knows the timing is tricky. It ended its second round of bond purchases in June 2011 only to see economic growth remain weak and unemployment stay at levels more consistent with a recession than a healthy recovery.
In part, that’s why the Fed is expected to move cautiously. Rather than end the bond-buying program altogether, it’s likely to reduce its purchases gradually — and perhaps only temporarily. That way, it can wait to see what happens to the economy before deciding whether to keep trimming its purchases.
Former Fed economist David Wyss, now a professor at Brown University, predicts that the Fed will trim its monthly bond purchases to $50 billion from $85 billion as early as this fall, and gradually reduce the pace to zero during 2014.
That the Fed is even considering a pullback in its bond-buying program is a testament to how far the economy has come from the depths of the Great Recession — though it remains far from full-health. Employers have added an average of 208,000 jobs a month since November, up from 138,000 during the previous six months. The unemployment rate has reached a four-year low of 7.5 percent, from 8.2 percent in July and a peak of 10 percent during 2009.
On Thursday, the Labor Department said the number of Americans seeking unemployment benefits fell 23,000 last week to a seasonally adjusted 340,000, a level consistent with solid job growth.
The housing market, which had been a drag on growth from 2006 through 2011, is recovering steadily. Sales of new homes rose in April, nearly matching the fastest pace in five years, and driving the median price to a record $271,600, the Commerce Department said Thursday.
Still, Fed Chairman Ben Bernanke on Wednesday told a congressional committee that the economy continues to need help. Among other concerns, he and some other Fed policymakers worry that tax increases and spending cuts that kicked in this year are slowing the economy.
All of which means the Fed is unlikely to reverse its easy-money policies without evidence that the economy is sturdy enough to withstand the government cutbacks and keep growing at a healthy pace.
Once it does, stocks may fall, at least temporarily. In the long run, though, a more robust economy would generate higher profits for U.S. corporations.
And that, in turn, would likely fuel higher stock prices.