By John W. Schoen Senior producer
updated 8/9/2011 4:58:47 PM ET 2011-08-09T20:58:47

The Federal Reserve's highly unusual promise — to keep interest rates low for "at least" the next two years — comes as panicky global financial markets are looking for reassuring measures from the U.S. central bank.

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Unfortunately, Fed Chairman Ben Bernanke and his colleagues have very few cards left to play.

"Effectively there are no policy levers left," Deutsche Bank chief economist Joseph LaVorgna told CNBC.

Following its regular policy-setting meeting Tuesday, the central bank announced that it expects to keep its key benchmark interest rate near zero through mid-2013, where it has fixed short-term borrowing costs since December 2008. The Fed had previously only said that it would keep short-term rates low for "an extended period."

Stock prices dropped sharply after the Fed's announcement but then bounced back with a vengeance. The Dow Jones industrial average, which had been down more than 200 points shortly after the central bank statement, ended with a gain of 430 points, or 4 percent.

Fed policymakers used significantly more downbeat language to describe current economic conditions than they had in recent months.

The Fed's rate-setting panel said the economy has grown "considerably slower" than the Fed had expected so far this year. Panelists said temporary factors, such as high energy prices and the crisis stemming from the earthquake and tsunami in Japan, only accounted for "some of the recent weakness" in economic activity.

Story: Wild day on Wall Street; Dow soars 430 points after Fed telegraphs a slow recovery

Since the Panic of 2008, the central bank has flooded the financial system with cash, spending $1.4 trillion to buy bonds backed by high-risk mortgages and snapping up another $900 billion in Treasury bonds. The Fed's easy money policy is designed to keep credit flowing after the collapse of a decade-long borrowing binge.

Despite that unprecedented intervention, the economy is barely growing, and economists see a growing chance of a second, "double dip" recession.

Fed officials have estimated that their bond buying spree may have lowered long-term interest rates by a half a percentage point. That means that if the Fed were to embark on another round of bond-buying it would have to be even bigger to have any meaningful impact, according to former Fed governor Lawrence Meyer.

"We're talking about a commitment of more than a trillion dollars, maybe closer to $2 trillion," he said. "Pushing long-term rates down by (half a) point? That's a gesture. That's nothing."

For now, the Fed will likely continue to use the relatively weak policy tools at its disposal. One is to promise to keep rates low. The Fed has already been making that promise for months, although now it has taken the unusual step of virtually setting it in stone for the next two years.

Another is to change the mix of its holdings. By selling short-term paper and buying more long-term bonds, the Fed can push long-term rates even lower. Those market-driven rates are benchmarks for a variety of consumers loans — from mortgages to car loans.

But pushing down longer-term rates also can hurt consumers, especially retired people living on fixed incomes, because it reduces the interest rates paid on savings.

"I agree there are great limits to what the Fed can do and how effective it can be," said Meyer. "But that doesn't mean you sit on the sidelines."

Fed officials insist that have a number of policy options left — some of them untested. Chairman Bernanke has suggested the central bank could cut the interest rate - now 0.25  percent — that it pays banks to keep cash in reserves. It could even charge banks to stash their cash in its reserve accounts.

Story: Fed says it will hold rates fast until mid-2013

In theory, that would prompt banks to put that money to work by lending more. But corporations are already flush with cash. Bankers say they have plenty of money to lend, but demand for loans remains weak as the economy has stalled.

For now, the Fed continue to forecast a moderate pick-up in growth in the second half of the year. If that changes, and the economy slips back into recession, the central bank could turn to more aggressive measures.

"The central bank was created to be a lender of last resort," said former Fed governor Randall Krozner. "There are things that could be done, but they're not necessarily things that will be done. But it's important to make sure that people are aware that the safety net is there in case things really go off the rails. That's why you have a central bank."

Still, the Fed would be very reluctant to turn to these measures unless another major financial crisis developed.

One option would be to expand its purchases to include riskier assets like stocks. Or it could "peg" longer term rates. Much as it uses its buying and selling of short term paper to hold the overnight lending rate near zero, the Fed could use its bond-buying power to peg a longer-term rate like the five-year Treasury bond.

It could decide to lift its inflation target — publicly tolerating a risk of losing control of prices in the name of reviving growth.

Even as the central bank is struggling to keep rates low and encourage more borrowing, the economy is being weighed down by forces outside of its control. Spending cuts at all levels of government are producing a major drag on growth.

"No wonder we haven't had this recovery: We're held back by all of this austerity," said Robert Brusca, chief economist at FAO Economics. "Why anybody talks about how austerity is the right thing to have after a recession, I don't know."

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      The Federal Reserve's highly unusual promise — to keep interest rates low for "at least" two more  years — comes as the central bank is running out of options to reassure panicky markets.

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Pressure to cut government spending intensified this week following Standard and Poor's decision to downgrade the Treasury's credit rating. That downgrade threatens to make credit tighter if it reduces the value of bonds held by U.S. banks.

"There's $2 trillion worth of government-guaranteed paper inside the banking industry," said Rochdale Securities banking analyst Richard Bove. "That paper in essence loses its value if you downgrade Fannie Mae and Freddie Mac or the United States government debt. Therefore, you're reducing the capital availability to the banks because you're reducing the size of their assets."

Then there's Europe, where the banking system is still suffering the hangover from a decade-long borrowing binge. European countries remain deadlocked over the best way to repair the damage. And many analysts doubt that Europe's central bank — which relies on those countries for funding — has enough money to cover widespread defaults by weaker European countries. Those fears have been intensified in recent weeks as investors have demanded sharply higher rates to offset the risk of default by Italy, Europe's third largest economy.

"If Italy can't pay its debt, we're all in trouble," said Larry Kantor, head of research at Barclays Capital.

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Video: CNBC on the Fed's announcement

Explainer: What is the the FOMC?

  • Image: Fed Chair Ben Bernanke
    Getty Images

    The Federal Reserve's chief policymaking group has vast power over the finances of ordinary people, businesses and investors. The consequences of its interest-rate decisions range wide: from people's ability to get affordable loans to the price of cereal at the grocery store or gasoline at the corner station.

    Here's a look at the policymaking group, called the Federal Open Market Committee.

  • What is the FOMC's primary role?

    Image: Employment Development Department office in San Jose, Calif.

    Its mission is to keep the economy, inflation and employment on a healthy track. When the economy weakens, Fed policymakers cut rates or keep them low. The idea is to cause people and businesses to borrow and spend more, which sustains the economy. But when the economy grows so fast that inflation becomes a threat, Fed policymakers will raise rates or keep them high. That makes it costlier for people to borrow. Spending and other economic activity will slow. Companies find it harder to raise prices. Inflation pressures ease.

  • How does the FOMC move interest rates?

    Image: TV shows rates unchanged

    Its policymakers decide whether to buy securities. Doing so expands the flow of money into the financial system and lowers the Fed's key interest rate. Conversely, the policymakers could decide to sell securities. That would drain money from the system and tighten credit by raising rates. The Federal Reserve Bank of New York is responsible for conducting these operations.

  • Who's on the committee?

    Image: Federal Reserve Board Governor Raskin

    It's composed of:

    • The Fed's Board of Governors in Washington, which now totals five members but at full strength has seven members.
    • The president of the Federal Reserve Bank of New York.
    • Four of the remaining 11 presidents of the Fed's regional banks. They serve one-year terms on a rotating basis.

    Here is Tuesday's roster of voting members: Fed Chairman Ben Bernanke, Vice Chairwoman Janet Yellen, and Fed Governors Elizabeth Duke, Daniel Tarullo and Sarah Bloom Raskin (pictured), all based in Washington; William Dudley, president of the Federal Reserve Bank of New York; Charles Evans, president of the Federal Reserve Bank of Chicago; Charles Plosser, president of the Federal Reserve Bank of Philadelphia; Richard Fisher, president of the Federal Reserve Bank of Dallas; and Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis.

    (President Barack Obama has nominated Peter Diamond to be a Fed governor, but the Senate hasn't confirmed him. Diamond, a professor at the Massachusetts Institute of Technology, shared the Nobel Prize in Economics in 2010. )

  • How often does the FOMC meet?

    Image: The Federal Reserve building

    It regularly meets eight times a year in person at the Fed's headquarters in Washington. During the financial crisis, the FOMC also held emergency meetings, mostly by video conference. This year, half the meetings were two-day sessions, the rest one-day. All the regularly scheduled meetings last year took two days. That was because the Fed needed time to devise unconventional programs to fight the financial crisis. Traditionally, one-day meetings are more common. Each one-day meeting runs roughly five hours. Two-day meetings run about eight hours spread over the two days.

  • Why are the FOMC's rate decisions issued around 2:15 p.m.?

    Image: Ben Bernanke on TV at NYSE

    Having a consistent time helps investors digest and react to the Fed's policy decisions. Issuing decisions when the markets are open gives Fed policymakers instant feedback from investors.

  • Why are some of the FOMC's rate decisions issued around 12:30 p.m.?

    Image: CNBC

    For the first time in the Fed's history, the chairman is conducting a series of regularly scheduled news conferences to discuss the Fed's forecast. Bernanke's first was held Wednesday. They will be held four times a year, after the Fed concludes its two-day meetings to update its economic forecasts on growth, employment and inflation. So, after those meetings, the FOMC's decisions are released earlier, around 12:30 p.m. Bernanke will then holds a news conference at 2:15 p.m. It's something that Bernanke's counterparts in Europe and Japan have done for years. The Fed is hoping the news conferences will improve its communications with Wall Street investors and the American public.

  • How are the FOMC's rate decisions approved?

    Image: Gavel
    Getty Images stock

    By a majority of the voting members, who now total nine. (At full strength, there would be 12.) That said, a close decision could spell trouble for the Fed chairman. It would suggest he can't win over policymakers to his side and could leave him weakened. Most votes are overwhelming, however, indicating that Fed chiefs are typically able to build consensus.

  • How are Fed officials selected?

    Image: President Barack Obama

    The president nominates the Fed chairman and his colleagues on the board of governors in Washington. They must be confirmed by the Senate. The presidents of the 12 regional Fed banks are appointed by each bank's board of directors, with approval from the Fed's board. A new law revamping financial regulation, however, bars bankers who sit on the regional boards from voting. Other local business people serving on the boards still retain their vote. This change was made to address concerns about potential conflicts of interest — having officials whose companies are overseen by the Fed in Washington picking the regional presidents.

  • How and why was the Fed created?

    Image: $100 bills

    Congress passed the Federal Reserve Act in 1913. The legislation was signed into law by President Woodrow Wilson on Dec. 23, 1913. The Fed began operating in 1914. It was created in response to a series of bank panics that plagued the United States during the 19th and early 20th centuries. Those panics led to bank failures and business bankruptcies that roiled the economy.


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