The Federal Reserve last month absorbed a wave of criticism for announcing it will buy $600 billion in Treasury bonds to try to revitalize the economy. It won't help, critics said.
So when Fed officials meet Tuesday, they're likely to feel a weight has been lifted: The White House and key Republicans have agreed on a tax-cut deal that's expected to do just what critics said the Fed's bond purchases wouldn't: Boost spending, spur hiring and speed economic growth.
Economists say they think the Fed will still carry out its full $600 billion bond-buying plan by the end of June as scheduled. Unemployment is 9.8 percent, and the economy needs all the help it can get.
But the tax-cut plan does make the Fed less likely to buy even more than $600 billion in bonds — something Chairman Ben Bernanke said it might do if the economy needed further help. No policy changes are expected at the Fed's meeting.
"The tax-cut plan reduces pressure on the Fed to have to buy more government securities," said Mark Zandi, chief economist at Moody's Analytics. "I think they are committed to $600 billion because they aren't certain how things will turn out. It's always possible the economy could rev up rapidly. But I think the odds are low the Fed will do less."
Zandi and other economists think the tax cuts will help stimulate growth over the next two years. And consequently, the Fed might have to raise record-low interest rates sooner than had been expected. That's because stronger growth increases the risk of high inflation, which the Fed fights by raising rates to cool the economy. The tax-cut plan will also swell the government's annual budget deficits, which are already running well over $1 trillion.
Zandi and others now think the Fed will start raising rates in late 2012, compared with early 2013 without the tax-cut plan.
The Fed announced its Treasury-purchase plan at its last meeting, Nov. 3. At the time, Congress seemed unlikely to do much on its own to strengthen the economy. Bernanke felt Congress' reluctance to approve new stimulative spending obliged the Fed to do what it could to further drive down interest rates.
But early this month, the White House and Republicans forged a broad tax-cut deal that seems likely to pass despite resistance from many Democrats. Among other things, the plan would extend 2001 and 2003 income-tax cuts for two years; renew long-term unemployment aid for 13 more months; reduce workers' Social Security taxes in 2011; and let companies increase their tax write-offs for capital investments next year.
The tax-cut package does raise the risk of higher interest rates resulting from a stronger economy. And critics say the Fed's bond purchases will contribute to inflation pressures because it will be flooding the financial system with dollars — essentially, printing more money.
Investors have already bid up the yield on the 10-year Treasury note in anticipation of higher inflation and higher rates. From a low of around 2.4 percent in early October, the yield on the 10-year Treasury has surged nearly a full percentage point to about 3.3 percent.
Lowering rates on mortgages and other loans, to make it cheaper to borrow, was a key goal of the Fed's bond-buying program. Instead, higher Treasury yields in recent weeks have raised mortgage rates, which tend to track long-term Treasury yields. The average rate on a 30-year fixed mortgage has reached 4.61 percent. That's up sharply from 4.17 percent a month ago, the lowest rate in the 40 years that records have been kept.
Yet in defense of the Fed, some economists say rates would be even higher now if not for the Fed's program to buy more Treasurys. And even the current slightly higher rates remain near historic lows. Most economists say the benefits of the tax-cut plan will outweigh the costs of slightly higher interest rates.
That's why economists are raising their estimates for economic growth. Zandi, for instance, has raised his forecast for economic growth next year from 2.7 percent to 4 percent.
It also helps explain why stock prices have been rising. The Standard & Poor's 500 stock index is at a new high for the year and is now trading at roughly the same price it did the week before Lehman Brothers filed for bankruptcy protection in September 2008.
Higher stock prices are helping households rebuild the wealth they lost to the recession. That, in turn, is spurring higher spending, especially by wealthier Americans.
At the same time, critics who worry about inflation and the nation's trillion-dollar budget deficits point to the tax-cut plan's estimated $855 billion cost over two years. Lawmakers have yet to agree on any long-term deficit-reduction plan.
Worries about runaway deficits and debt could inflame inflation fears. Bond investors would demand ever higher returns to lend their money. A sharp run-up in interest rates would slow the economy.
The current roughly 3.3 percent yield on the 10-year Treasury is still low enough to support strong growth, economists say. But the higher it goes, the bigger the drag on growth as higher rates ripple through the economy.
"Once it exceeds the 5 percent threshold, the recovery is in danger of stalling," said Bernard Baumohl, chief economist at the Economic Outlook Group. "Higher borrowing costs will cool business and consumer spending."
Baumohl said he worries the Fed's bond-buying program may prove counter-productive if "bond investors increasingly worry that additional monetary stimulus, in conjunction with the latest stimulative tax deal, will cause inflation expectations to flare up."
At their meeting Tuesday, Bernanke and his colleagues will likely discuss the effect of the tax-cut deal on the Fed's efforts to stimulate the economy. But with scant likelihood of any Fed policy changes, attention has turned instead to the tax-cut plan emerging in Congress — its benefits and its risks.
And no one is looking anymore at the Fed to rescue the economy alone.
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