Why the Fed is Lukewarm on the U.S. Recovery

Unemployment has dipped, but the economy is in bad shape...and will be for a while.

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 At its most recent meeting, the Federal Reserve's Open Market Committee stated that interest rates may have to remain near zero for at least another two years.

Translation? The recovery will continue to be slow and prolonged—possibly even more than was once thought.

The Fed has kept interest rates near zero since late 2008 in a bid to stimulate the economy. In August, the Fed first put a time stamp on that rate, saying it expected those rates to be necessary through mid-2013. So last week, when the Fed forecast that low interest rates could stay that low through late 2014, especially after a flurry of promising economic data—improving GDP, decreasing jobless rates—it seemed unexpected. Aren't things getting better?

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They are, but in all the fuss over periodic positive blips in the data, it is easy to forget the long view for the U.S. economy is still troubling, says Guy LeBas, chief fixed income strategist for Janney Montgomery Scott. "I think the Fed is looking through the short-term improvement in the data, just as last summer they looked through the short-term deterioration in the data."

Last summer, the U.S. economy took a beating. Unemployment inched up to 9.1 percent, the stock market plummeted and a congressional debt limit fight causing rating agency Standard & Poor's to issue an unprecedented U.S. credit rating downgrade. Yet the Fed was measured in its response, choosing in September to lengthen the maturity of its balance sheet.

Half a year later, the U.S. economy seems to have put those wobbles in its rearview mirror, with unemployment at 8.5 percent and 2011's fourth-quarter GDP growth at 2.8 percent, as the Commerce Department reported last week. However, the Fed still fears that long-term growth remains constrained. "Growth is improving, but it's capped. It's almost as if it's rattling around inside this box. It gets better, it gets worse, but it's not getting out of the box," says LeBas. "The Fed is more concerned about the size of the box rather than about where exactly the economy is inside that box."

If 2011 is any guide, even last week's apparent acceleration in GDP may be misleading. First-quarter GDP growth in 2011 was ultimately revised down from 1.8 percent to 0.4 percent. Third-quarter growth was eventually revised down from 2.5 to 1.8 percent. As Mike Mussio, portfolio manager at FBB Capital Partners, points out, last week's figure could easily turn into a disappointment if that trend continues.

Additionally, the elephant in the room—or rather, across the Atlantic—in any discussion of the U.S. economic future is Europe and its continuing debt crisis. Until the European Union works out how to save its most indebted members from traumatic defaults, that crisis will loom as a major threat to U.S. economic stability.

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Altogether, the Fed has exhausted most of its stimulative tools, says LeBas. Low interest rates are intended to stimulate the economy in part by encouraging borrowing and business investment, and three years after near-zero rates were put in place, recovery still seems elusive.

Therefore, being clear about its intentions may be one of the few tactics that the central bank can undertake. "The Fed is trying to provide some type of clarity to investors, to employers, to businesses," signaling to them that cheap borrowing will still be in place for 30 more months, says Mussio.

LeBas adds that low interest rates can provide stimulus by making saving less attractive (and, therefore, making spending more attractive). By signaling that interest rates will remain low for an extended period of time, he says, the Fed is "trying to alter decisions made over a several-year timeframe."