The United States Federal Reserve’s recent announcement that it will extendits “Operation Twist” by buying anadditional $267 billion of long-term Treasury bonds over the next six months -to reach a total of $667 billion this year - had virtually no impact on eitherinterest rates or equityprices. The market’s lack of response was an important indicator thatmonetary easing is no longer a useful tool for increasing economic activity.

The Fed has repeatedly said that it will do whatever it can to stimulategrowth. This led to a plan to keep short-term interest rates near zero untillate 2014, as well as to massive quantitativeeasing, followed by Operation Twist, inwhich the Fed substitutes short-term Treasuries for long-term bonds.

These policies did succeed in lowering long-term interest rates. The yieldon ten-year Treasuries is now 1.6%, down from 3.4% at the start of 2011.Although it is difficult to know how much of this decline reflected higherdemand for Treasury bonds from risk-averse globalinvestors, the Fed’s policies undoubtedly deserve some of the credit. The lowerlong-term interest rates contributed to the small 4% rise in the S&P 500share-price index over the same period.

The Fed is unlikely to be able to reduce long-term rates any further.Their level is now so low that many investors rightly fear that we are looking at a bubble in bond and stock prices. The resultcould be a substantial market-driven rise in long-term rates that the Fed wouldbe unable to prevent. A shift in foreign investors’ portfolio preferences awayfrom long-term bonds could easily trigger such a run-upin rates.

Moreover, while the Fed’s actions have helped the owners of bonds andstocks, it is not clear that they have stimulated real economic activity. The USeconomy is still limping along with veryslow growth and a high rate of unemployment. Although the economy has beenexpanding for three years, the level of GDP is still only 1% higher than it wasnearly five years ago, when the recession began. The GDP growth rate was only1.7% in 2011, and it is not significantly higher now. Indeed, recent data showfalling real personal incomes, declining employment gains, and lower retailsales.

The primary impact of monetary easing is usually to stimulate demand forhousing and thus the volume of construction. But this time, despitehistorically low mortgage interest rates, house prices have continued to falland are now more than 10% lower in real terms than they were two years ago. Thelevel of real residential investment is still less than half its level beforethe recession began. The Fed has noted that structural problems in the housingmarket have impaired its ability tostimulate the economy through this channel.

Business investment is also weak, even though large corporations have veryhigh cash balances. With so much internal liquidity, these businesses are notsensitive to reductions in market interest rates. At the same time, many verysmall businesses cannot get credit, because the local banks on which theydepend have inadequate capital, owing to accrued losses on commercial real-estate loans.These small businesses, too, are not helped by lower interest rates.

The Fed’s monetary easing did temporarily contribute to a weaker dollar,which boosted net exports. But the dollar’s decline has more recently been reversed by the global flightto safety by investors abandoning the euro.

Even if the USeconomy continues to stumble in the monthsahead, the Fed is unlikely to do anything more before the end of the year. Thenext policy moves to help the economy must come from the US Congress and theadministration after the November election.

Nonetheless, what needs to be done is already clear. The cloud of a sharprise in personal and corporate income-tax rates, now scheduled to occurautomatically at the start of 2013, must be removed. The projected increase inthe long-term fiscal deficit must be reversed by stemmingthe growth in transfers to middle-class retirees. Fundamental tax reform muststrengthen incentives, reduce distorting “tax expenditures,” and raise revenue.Finally, the relationship between government and business, now quite combative, must be improved.

If these things happen in 2013, the US economy can return to a morenormal path of economic expansion and rising employment. At that point, the Fedcan focus on its fundamental mandate of preventing a rise in the rate ofinflation. Until then, it is powerless.