Sep.14 Trading Stocks.- The Federal Reserve wasn't just trying to drive down interest rates when it announced a third round of bond purchases Thursday. It also wants to make people feel wealthier — and more willing to spend. The idea is for the Fed's $40 billion-a-month in bond purchases to lower interest rates and cause stock and home prices to rise, creating a "wealth effect" that would boost the economy. And "if people feel that their financial situation is better because their 401(k) looks better or for whatever reason — their house is worth more — they're more willing to go out and spend," Chairman Ben Bernanke told reporters. "That's going to provide the demand that firms need in order to be willing to hire and to invest." Sure enough, stocks have surged since the Fed announced plans to buy mortgage bonds as long as it feels necessary — a policy known as "quantitative easing," or QE. And since Bernanke gave a speech Aug. 31 more or less confirming that QE3 was on the way, the Dow Jones industrial average has jumped more than 500 points, about 4 percent. Stocks tend to rise when investors expect lower interest rates. In part, that's because some investors shift money out of low-yielding bonds and into stocks, which are riskier but offer potentially higher returns. And lower rates can spark more spending and boost corporate profits.
Still, economists say the wealth effect from higher stock prices tends to be modest. And some caution that home prices might not rise much as long as many would-be buyers can't qualify for mortgages.
In addition to the bond purchases, the Fed said it expects to keep short-term rates super-low at least through mid-2015, six months longer than it previously planned. And it said it would probably hold rates low even after the economic recovery has strengthened — a sign that it will intervene until the economy starts growing fast enough to reduce unemployment sharply.
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