Following the Federal Open Market Committee (FOMC) meeting held less than two weeks before Christmas, investors reacted as if the Grinch had sneaked down their chimneys and stolen every present and decoration.
In truth, the FOMC didn't take anything away--it just didn't provide any new stimulus. That shouldn't alter the course of economic fundamentals, but jittery stock market investors who have grown addicted to artificial stimulants from the Fed showed painful signs of withdrawal.
The federal funds rate
In terms of outcomes, the Fed announcement chiefly reiterated four existing policy stances:
- Keeping the federal funds rate between 0 and 0.25 percent.
- Moving ahead with Operation Twist, lengthening the average maturity of its holdings to bring longer-term interest rates down.
- Continuing to reinvest in mortgage-backed securities to support that segment of the market.
- Forecasting that these policies are likely to remain in place until at least mid-2013.
In the process, the Fed noted that the consumer segment of the economy seemed to be making progress, but also acknowledged a key wild card: "strains in global financial markets," a not-so-veiled reference to the European debt crisis.
While there were no new initiatives in this announcement, this is far from a passive stance on the part of the Fed. The extreme low interest rate policies of the Fed represent an aggressive, ongoing attempt to support economic growth. Naturally, it can take some time for such policies to take effect, and it would be unrealistic--even dangerous--to expect the Fed to come out with bold new initiatives every time the FOMC meets.
Market reaction vs. economic reality
Even though there are signs of progress in the economy and little left that the Fed can do to help anyway, the stock market went into a funk on the news that the outcome of the meeting was to maintain the status quo. To explain this reaction, it may help to examine where the interests of stock investors and those of the economy at large may diverge a little bit.
Fundamentally, stocks are valued based on the projected value of future earnings, discounted by interest rates. This sets up an equation for stock valuations where earnings are the numerator, and interest rates are the denominator. Mathematically, the value of this equation can rise if the numerator is increased, or if the denominator is decreased.
In other words, stock prices can rise if earnings grow--or if interest rates fall. The stock market was looking for a quick fix from the Fed yesterday in the form of even lower interest rates, but it didn't get it. For the economy as a whole, though, what matters is earnings growth, and that is simply going to take a little longer to develop. So the Fed isn't really the Grinch, but then again, it isn't Santa Clause either.
MoneyRates.com Interest Rate Forecast: 2011-2012
January 24th-25th, 2012: 0 to 0.25 percent
March 13th, 2012: 0 to 0.25 percent
April 24th-25th, 2012: 0 to 0.25 percent
June 19th-20th, 2012: 0 to 0.25 percent
July 31st, 2012: 0.25 percent
September 12th, 2012: 0.25 percent
October 23rd-24th, 2012: 0.25 percent
December 11th, 2012: 0.25 percent
About the Federal Reserve
The Federal Reserve serves as the central bank of the United States. It was founded in 1913 by Congress for the purpose of strengthening the nation’s financial and monetary stability. Today, the Fed serves several duties in the nation’s economy.
These roles include regulating financial institutions, seeking to foster prosperity in the financial market, providing services to financial institutions, and influencing credit and monetary conditions for the purpose of a stable economy.
The Federal Open Market Committee (FOMC) meets several times each year and steers many key parts of Federal Reserve policy, including guiding the target range of the federal funds rate. The committee consists of 12 members.
Federal Reserve policy options
Options the Federal Reserve has for manipulating the economy include:
- Altering the federal funds rate target
- Altering the discount rate and its spread from the federal funds rate
- Making open-market purchases of mortgages securities and Treasury bonds
- Revising the language in the Fed's official statement to extend the period of time that interest rates are anticipated to be low
- Increasing the money supply
Federal Reserve Links
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