Will the Tax Deal Give the Fed a Helping Hand?

When the Federal Reserve's interest rate-setting committee announced last month that the Fed would buy $600 billion of bonds, the idea was to force down interest rates as a way of stimulating the economy. But a funny thing happened: Long-term rates have instead gone up sharply. Does the Fed need to retool its policy?

The Federal Open Market Committee meets today to discuss monetary policy and is widely expected to make no changes to interest rates or its bond-buying program, which has been dubbed quantitative easing (with the latest $600 billion program dubbed QE2).

One reason the Fed may not have to act is that President Obama has already moved to boost the economy further, thanks to the tax deal last week that includes a 2% cut in the Social Security payroll tax. That's expected to provide an additional stimulus of about $120 billion.

"Obviously, the market and the Fed did not anticipate we were going to get this sizable fiscal plan put in place," says Tom Porcelli, chief U.S. economist at RBC Capital Markets in New York. "I think you cannot underestimate what these tax cuts are going to do for growth next year."

Porcelli says last week he revised his GDP forecast upward by a full percentage point, to 3.1%, the most he has ever raised his GDP forecast in a single day.

Moving Investors "Off Their Rear Ends"

David Rosenberg, chief economist at Gluskin Sheff in Toronto, says the rise in interest rates should not be viewed as a failure of quantitative easing. "If the end goal was to move investors off their rear ends and engage in more risk, you can argue that it actually has met its ultimate goal of triggering a rise in asset prices, specifically equities, in order to generate a positive wealth effect on spending," Rosenberg says.

The Dow Jones Industrial Index has risen 14% since Fed Chairman Ben Bernanke first mentioned the possibility of QE2 on Aug. 27.

Rosenberg expects the Fed statement, to be issued at 2 p.m. Tuesday, to take stock of the fact that the housing market remains depressed and that labor market conditions are still tepid.

On the other hand, Rosenberg says, the consumer has surprised economists to the upside. Retails sales numbers have been buoyant, the holiday shipping season has come in above expectations so far and consumer confidence is a little better than expected.

Good for Stocks, Bad for Mortgages

"When you add it all up, the Fed will have a slightly better tune to the economic backdrop, with nothing to suggest we're out of the woods yet, and a commitment to quantitative easing," Rosenberg says. He adds that he thinks the Fed will commit to spending the entire $600 billion on buying Treasury bonds as it announced in November. The Fed said it would complete the spending package by the middle of next year.

On Monday alone, the Fed spent $7.8 billion buying Treasury bonds, which did have the effect of driving down long-term rates from their high of 3.36% to 3.28%. But that's still substantially above the 2.48% that prevailed on Nov. 3, when QE2 was officially announced.

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One concern the Fed faces is that while quantitative easing may have helped the stock market, the rise in bond yields has meant a parallel increase in mortgage rates, which has hurt the housing market's recovery.

But Porcelli argues that low interest rates didn't help the market much either. "Even when mortgage rates were well below here, it was not juicing growth anyway," he says. "There is no real remedy the Fed can set forth."

Porcelli says a major concern has to be the Fed's exit strategy from the bond-buying program. "At some point, we have to exit from this, and I think it could get pretty ugly," he says.

A number of economists have pointed out that when the Fed stops buying bonds and instead starts selling them, prices could really tumble, sending interest rates up dramatically and crushing the recovery. But again, no one ever said the Fed's job was easy.