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To savers' dismay, Fed shows no sign of budging on short-term interest rates

December 17, 2010|Tom Petruno | Market Beat

When the Federal Reserve pushed its key short-term interest rate to near zero two years ago this week, it did so to battle a monumental credit crunch that threatened the entire U.S. financial system.

But that rate was supposed to be temporary — emergency economic stimulus for a true emergency, and a way to keep banks afloat by slashing their cost of money, particularly for savers' deposits.

Two years later, the financial-system emergency has passed. Bank failures continue to rise, but the survivors are making plenty of money. Banks' net income totaled $53.6 billion in the first nine months of this year, up sharply from $3.2 billion in the same period of 2009, according to the Federal Deposit Insurance Corp.

Yet the Fed's emergency interest rate remains in effect, at a painful ongoing cost to those millions of savers who can't take the risk of moving their money into stocks, bonds or other investments that could lose value.

The banks clearly are benefiting as many people try to do the right thing for their financial health by saving more. Domestic deposits rose to a record $7.74 trillion at the end of the third quarter, 7% higher than the level of two years earlier.

By contrast, the interest the banks paid on those deposits amounted to just $14.5 billion last quarter, 57% less than what they put in savers' pockets in the same period of 2008, as the credit crisis was deepening.

Over the last year, banks have continued to reduce deposit rates overall. The average annualized yield on a six-month certificate of deposit was a mere 0.45% this week, down from 0.82% a year ago, according to Informa Research Services in Calabasas.

Even if you agree that rock-bottom interest rates were necessary to stave off economic collapse, the issue now is how long this extreme saver-to-bank subsidy — or, more broadly, saver-to-economy subsidy — should go on.

It will end only when the Fed agrees, because the central bank directly controls short-term rates. When it votes to raise them, deposit rates will follow.

There is, of course, far more at stake here than just savers' interest earnings. When the Fed finally decides to lift rates, it will be endorsing the idea that the economy is on a path to some semblance of normalcy.

But officially Fed policymakers aren't showing any sign of budging from their near-zero rate policy, despite increasing signs that the economic recovery is picking up speed.

In the statement following their final 2010 meeting on Tuesday, they reiterated that they expected to keep rates at "exceptionally low levels … for an extended period."

How long could "extended" be? Many economists now believe that the Fed won't boost short-term rates before 2012. Some see no movement before 2013.

Ethan Harris, who heads developed-markets economic research at Bank of America Merrill Lynch in New York, expects the first Fed rate hike in the fourth quarter of 2012 — a full two years away.

He noted that Fed Chairman Ben S. Bernanke has made clear the central bank wants to see significant declines in the unemployment rate, now 9.8%. Before the Fed begins to signal its readiness to raise rates, "They're going to need to see the rate fall below 9% or maybe 8.5%," Harris said. And that, he said, won't happen any time soon.

For Bernanke, then, holding short-term rates near zero no longer is about a banking emergency, but about an employment emergency.

But that also raises the question: Are rock-bottom rates really necessary for employment gains to happen at this stage of the recovery?

John Silvia, chief economist at Wells Fargo Securities in Charlotte, N.C., makes the case that credit costs in general aren't a major issue for many companies trying to decide whether to hire.

"It's more a matter of businesses being more confident about final demand" for their products or services, he said.

In any case, financial markets may pose a challenge to the Fed on short-term rates well before the jobless rate gets to 8.5%.

Longer-term interest rates on Treasury, corporate and municipal bonds have jumped over the last two months as the economic outlook has improved. That move has occurred even though the Fed last month committed to buying an additional $600 billion in Treasury securities by mid-2011 to keep bond yields down and pump more cash into the economy.

The Fed made no mention of the rise in longer-term rates in its statement Tuesday. "They're totally divorcing themselves from the market, and from the market reaction to their policies," said Ed Yardeni, an economist and head of Yardeni Research in New York.

The Fed may well figure that the rebound in bond yields is just a normal snap-back from very low levels reached in late summer and early autumn. The 10-year Treasury note yield, a benchmark for other interest rates, has surged to 3.32% from 2.39% in early October. But it's still below the 2010 peak of 3.99% reached in April.

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