Fed Says U.S. Economy Still Needs Low Rates After Markets Heal

By Scott Lanman

Dec. 17 (Bloomberg) -- Federal Reserve officials declared financial markets healthy enough to remove most emergency aid without going as far on their support for the U.S. economy.

The Fed, after concluding a two-day meeting yesterday, said most of its lending programs would expire as scheduled Feb. 1 because of “improvements in the functioning of financial markets.” Policy makers said the labor market is stabilizing yet kept a pledge to keep interest rates “exceptionally low” for an “extended period.”

The statement reinforced economists’ forecasts that the Fed will wait from six months to a year before raising borrowing costs. By confirming plans to end its aid to bond dealers, short-term debt markets and money-market mutual funds, the Fed signaled it sees a waning in the “unusual and exigent” conditions that prompted creation of the programs in 2008.

“The nastiness of the storm has dissipated,” said Paul Ballew, a former Fed economist who’s now a senior vice president at Nationwide Mutual Insurance Co. in Columbus, Ohio. “Concern about the financial market has passed, but they’re looking at weak labor markets and sluggishness in the real economy.”

The Fed’s Open Market Committee, in a unanimous decision, left its target for the benchmark interest rate unchanged in a range of zero to 0.25 percent. The central bank cut the rate on overnight interbank loans to that level a year ago.

The Senate Banking Committee is scheduled to vote today on recommending Fed Chairman Ben S. Bernanke’s nomination for a second term to the full Senate for approval. The panel meets at 9:30 a.m. in Washington. While a majority have said they will probably support Bernanke, some lawmakers fault his handling of the financial crisis and plan to oppose his reappointment.

Stocks Rally

Stocks have rallied as low interest rates have caused investors to seek higher returns. The Standard and Poor’s 500 Index is up 23 percent this year. The Fed’s purchases of $1 trillion in mortgage-backed securities helped push the average rate on a 30-year fixed-rate home loan to 4.71 percent in the week ending Dec. 3, the lowest since mortgage buyer Freddie Mac of McLean, Virginia, began keeping records in 1971.

The Libor-OIS spread, a gauge of banks’ willingness to lend, has narrowed to 0.10 percentage point, from a record 3.64 points in October 2008. The TED spread, the difference between what the Treasury and banks pay to borrow dollars for three months, has narrowed to 0.22 percentage point, from as high as 4.64 percentage points in October 2008.

Yesterday, the central bank retained its March deadline of completing the $1.25 trillion in mortgage-backed securities purchases and $175 billion of federal agency debt. Officials are gradually slowing the pace of purchases.

‘More Supportive’

Data since the FOMC’s last meeting Nov. 3-4 indicate that “economic activity has continued to pick up and that the deterioration in the labor market is abating,” the statement said. “Financial market conditions have become more supportive of economic growth,” while the economy is “likely to remain weak for a time,” policy makers said.

“They upgraded the growth outlook a bit,” said James O’Sullivan, chief economist at MF Global Ltd. in New York. “Officials are signaling more optimism on growth and more confidence in a sustained recovery. They are not ready to signal an imminent rate hike yet.”

Central bankers omitted a sentence from previous statements saying the Fed will “employ a wide range of tools” to promote growth and stable prices, and another saying the Fed is “monitoring the size and composition of its balance sheet.”

Dollar Loans

The Fed said it would end four emergency-lending programs as scheduled Feb. 1, keeping a deadline set in June, and work with foreign central banks to close currency swaps that provided dollar loans to banks outside the U.S.

The programs include aid to money-market funds, which began in September 2008 after the failure of Lehman Brothers Holdings Inc.; a backstop to the market for commercial paper, or short- term debt issued by corporations, which started in October 2008; and two plans backing bond dealers, which began in March 2008.

The total balances of the assistance plans dropped to $30.5 billion as of Dec. 9 from $1.17 trillion a year earlier.

“By allowing these programs to expire, the Fed no longer thinks we’re in unusual and exigent circumstances, although we are in circumstances that still require zero percent interest rates for an extended period,” said John Ryding, founder and chief economist at RDQ Economics LLC in New York and a former Fed researcher.

Employers cut payrolls by 11,000 jobs in November, the fewest in 23 months, and the unemployment rate fell to 10 percent from 10.2 percent.

Bernanke said in a Dec. 7 speech that the economy still faces “formidable headwinds” in the form of tight credit and a weak labor market.

“The real test will be: Will the Fed really end mortgage- backed securities purchases by the end of the first quarter?” said John Silvia, chief economist at Wells Fargo Securities LLC in Charlotte, North Carolina. “It will cause mortgage rates to rise because the Fed is such a big buyer. A lot of builders and real estate agents are going to be screaming.”

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net.