The Fed for the first time tied its policy of holding interest rates to near zero to a target unemployment rate after its meeting on December 12.
Interest rates will stay at historic lows until the unemployment rate reaches 6.5%. It currently is 7.7%.
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A caveat has to do with inflation. If the Fed sees inflation going above 2.5%, it will begin to raise interest rates. The Fed also voted to continue its program of buying a combination of $85 billion in Treasuries and mortgage-backed securities each month.
The Fed also does not expect the unemployment rate to fall below the new target rate for another three years.
The announcements clarified a policy shift announced after the September meeting of the Federal Open Market Committee (FOMC).
In its statement after today’s meeting, the Fed also made clear that it was not responding to what it viewed as new threats to the economy. Rather, it was continuing its efforts to resolve ongoing economic issues from the 2008 crisis.
The slow pace of inflation has given the Fed the room it needs to add stimulus to the economy without fear of igniting inflationary pressures.
Its monthly purchases will also be funded differently. It has essentially ended its Operation Twist program in which the Fed sold long-term securities and used those funds to purchase short-term securities.
Instead, money will be created to fund the monthly purchases of both Treasuries and mortgage-backed securities.
Several Fed officials have said they see positive economic effects from the mortgage-backed purchases, even more than from the Treasury purchases. The effect of lower borrowing costs for investors tends to encourage spending.
But the Fed has already purchased over half of the volume of new mortgage securities that will cause it to overtake the private market. This leaves the Fed little room
for further stimulus.