Fed to keep rates low for two years, stocks jump

 The Federal Reserve building in Washington, June 29, 2011.

By Pedro da Costa and Mark Felsenthal

WASHINGTON | Tue Aug 9, 2011 7:41pm EDT

(Reuters) - The Federal Reserve on Tuesday took the unprecedented step of promising to keep interest rates near zero for at least two more years and said it would consider further steps to help growth, sparking a rebound in stocks.

The Fed painted a gloomy picture, saying that U.S. economic growth was proving considerably weaker than expected, inflation should remain contained for the foreseeable and unemployment, currently at 9.1 percent, would come down only gradually.

An unusually divided central bank pledged to hold benchmark rates at rock-bottom lows until mid 2013, and opened the door to other tools to support growth. The announcement demonstrated just how long the central bank expects it will take before a flagging economy can gather significant momentum.

"The statement was extremely negative in its outlook on the economy," said Omer Esiner, chief markets analyst at Commonwealth Foreign Exchange in Washington.

"By pegging the extraordinarily low interest rates to a date in the distant future, the Fed has essentially said that they see the current level of weakness lasting far longer than previously expected."

Financial markets, hungry for support from the Fed after bruising losses the past eight days that wiped $3.8 trillion from global stock portfolios, were jolted by the news.

U.S. stocks sank initially and then see-sawed wildly before a strong rally. The Dow ended up 4 percent at 429.92. Treasury yields sank with the 2-year note plunging to a record low of 0.1647 percent and the dollar sinking.

But there was doubt over how long the rally might last given the weak outlook. In a Reuters poll of primary dealers who trade directly with Fed, an increased number said they expected that the central bank will have to fire off another gun before long -- buying bonds to lower rates even further, known as quantitative easing.

The poll found that 37.5 percent now see the Fed resuming bond-buying within the next six months, compared with 27.5 percent who had expected more QE within two years when they were polled last Friday.

"If they have to act, they will," said Alberto Bernal, head of emerging markets fixed-income research at Bulltick Capital Markets. "They didn't act today because they didn't want to send a specific message of panic."

The Fed said that three policymakers dissented, the biggest such rebellion since 1992, pointing to unusual uncertainty about the outlook and reticence within the Fed about the effectiveness of unconventional policy.

NEXT CLUE

Markets will now be looking to Fed Chairman Ben Bernanke's yearly speech at the upcoming Jackson Hole meeting for further clues into any additional policy easing the Fed might consider at its next policy meeting, in September.

There is plenty of doubt about the Fed's power to stimulate the economy with rates already so low.Japan provides a disheartening example of a country that has kept borrowing costs low for many years without any notable spike in growth.

Dissenting against the decision were Richard Fisher of the Dallas Fed, Narayana Kocherlakota of Minneapolis and Charles Plosser of Philadelphia, who wanted to avoid any specific time reference on the low-rates pledge.

"The committee currently anticipates that economic conditions -- including low rates of resource utilization and a subdued outlook for inflation over the medium run -- are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013," the Fed said.

It also reiterated its policy of reinvesting the proceeds from bonds maturing in its portfolio, though it did not state a specific timeframe for such actions.

One analyst said the Fed's language left open the possibility of a third round of bond-buying, referred to as quantitative easing.

"They certainly didn't close the door on QE3," said Michael Yoshikami, chief investment strategist at YCM Net Advisors in Walnut Creek, California.

IS IT ENOUGH?

The Fed's decision comes amid financial market turmoil as worries about the global economy escalate after an embarrassing downgrade of U.S. debt. In addition, fears remain that European efforts to put a safety net under heavily indebted Italy and Spain may not suffice to avert wider credit market disruptions.

In an attempt to tamp down market volatility, finance ministers and central bankers of the Group of Seven major world economies held a telephone conference on Sunday and then issued a statement saying they were ready to act to ensure global stability.

Officials had been pinning hopes for an acceleration of U.S. growth in the second half of the year on a healing of supply chain disruptions from Japan's natural disasters, a calming of Europe's debt problems as governments committed to more sustainable fiscal paths and steady gains in business and consumer confidence in the United States.

But those expectations, along with the Fed's forecast for a growth rate of between 2.7 percent and 2.9 percent in 2011, have appeared increasingly over-optimistic in recent weeks.