How long will the Federal Reserve's helping hand keep guiding the U.S. economy?
The answer still seems to be "as long as it takes." In the meantime, fears about "tapering," the gradual wind-down of billions in monthly Fed bond purchases that's keeping interest rates low now, have caused widespread confusion and market volatility. For people buying homes, refinancing debt or investing for retirement, it's an important question. The Fed itself has said repeatedly that it will stay the course until the recovery is assured.
The real debate centers on the actual strength of the economy and what it says about Fed policy. Mixed signals on that score have caused markets to churn in recent weeks, marked by waves of record short-term fund flows in and out of equities, gold and bond funds.
Experts warn that people are reading too much into day-to-day events such as the timing of the taper. "Investors need to be careful. They can get really whipsawed," says Jerry Webman, chief economist for OppenheimerFunds. "You really need to not get caught up in these short-term market fluctuations and announcements."
What is the source of the confusion?
There is no timetable for Fed policy on rates. Back in June, Federal Reserve Chairman Ben Bernanke said the Fed might taper as early as September, but only if conditions were right. By holding off on that action this month, the central bank clearly showed it will wait to do so until the economy can manage higher rates. It will not be bound to any timetable. Its focus is entirely on the economy.
Tapering itself has been too big a focus. The unusual bond-buying program was a response to a unique situation. Long-term rates were stubbornly high despite years of Fed easing. The 30-year Treasury yield plummeted to an all-time low below 2.5 percent, and 30-year fixed mortgage rates followed to their lowest level ever at below 3.5 percent.
Those rates have since popped higher but still remain "well below the level of mortgage rates even at the peak of the housing boom," Webman says. The 30-year average has risen above 4 percent and could edge higher, Webman says. Still, mortgage rates are well below where they were even at the peak of the last housing boom, and they're affordable enough to allow a healthy level of home purchases to continue (however, higher rates have slowed refinancings, which are based entirely on relative interest-rate levels and not on affordability measures. People get refis only when rates are dropping.)
Meanwhile, the Fed will do what it has been doing for years, providing enough credit for the economy to grow. In a note to clients after last week's Fed meeting, Fran Rodilosso, fixed-income portfolio manager at Market Vectors ETFs, said he believes "easy money is a given into 2015."
The Fed does not need to continue its long-term bond buying to keep rates low, Rodilosso says. It can influence a broad range of consumer and professional lending by using short-term rates, something it has done effectively for years.
"The Fed has been managing the economy to various degrees since the mid-1950s," says Fred Dickson, chief investment strategist at D.A. Davidson. "I don't see that changing in the next decade."
The decision not to taper does not mean the economy is sliding, as some suggest. Despite big market swings, there has been little change in the economy this year. It has continued to expand at a modest rate of just over 2 percent, and it is expected to keep doing so.
The Fed's disclosure that it might pull back from its unusual bond-buying plan was not based on any dramatic change in the economy, but on the view that things have not improved enough for a policy change. "The economy will keep growing gradually if nothing drastic comes out of the current budget deliberations," Webman says.
The budget uncertainty was one of the reasons the Fed held off on taking action at its September meeting, economists agree. That political showdown could lead to cutbacks in federal spending that could put a new drag on the economy. September also began with a relatively weak employment report that played a role in the Fed's decision.
But those two factors don't point to an economy sliding back into a recession. Growth has been slow and steady. "Much of the economy has the potential to stand alone without extra stimulus," says Dickson, citing autos, health care and technology as areas that could perform well even without it.
Despite massive outflows from bond funds, not all forms of income are dangerous. Investors, meanwhile, have been bailing out of bond funds for months, and analysts have agreed that it's not a bad idea to limit exposure to long-term government debt. But there are ways investors can stay invested, even in income.
"Dividend growth stocks and short-duration bond ladders [bonds that mature at different time intervals from short to long] should provide average returns with modest risk," says Dickson, who adds, "This is not the right market climate to chase high-risk stocks or high-yield speculative bonds or leveraged bond funds."
S&P Capital IQ's head of ETF and mutual fund research, Todd Rosenbluth, says he screened for funds made up of relatively short-duration bonds that may offer solid yields even when rates rise. Among the funds that fit the criteria were the Metropolitan West Total Return bond fund, Vanguard Intermediate-Term Investment-Grade fund, Guggenheim BulletShares 2016 High-Yield Corporate Bond ETF, iShares 3-7 Year Treasury bond ETF and the PIMCO Enhanced Short Maturity exchange-traded fund.
Listen to the Fed – it's not trying to mislead anyone. The Fed gave an unusually specific warning to investors in advance of its plan to cut back on its quantitative easing, and has been far more open in terms of communicating its plans with investors than in the past.
In a speech this week, the influential president of the Federal Reserve Bank of New York, William Dudley, gave more information on what the Fed is watching. The Fed, he says, needs to see "continued improvement in the labor market" before it stops tapering.
Unemployment has already dropped from the double-digit level of the recession to 7.3 percent in the latest monthly report, but that is still worse than any month in the 25 years prior to the financial crisis. Things are better than they were in the recession, but since then, "the economy has been recovering very gradually. Nothing has changed much," Dickson says.