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Fed Plans 600 Billion Dollar Bond Purchase to Spark Economy

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By Don Lee

RISMEDIA, November 5, 2010—(MCT)—In the wake of congressional elections that weakened President Barack Obama and slammed the door on any new economic stimulus, the Federal Reserve unveiled a controversial new plan to spur the faltering U.S. economy by pumping $600 billion into the financial system.

The Fed’s much-anticipated but unconventional strategy is aimed at driving down long-term interest rates in the hopes of spurring more home refinancing and other borrowing and spending by consumers and businesses.

Together with funds from an existing purchase program, the central bank could now buy as much as $900 billion in new Treasury bonds by the end of June of next year. And Fed officials left open the possibility of upping the ante, depending on the evolving economic conditions.

Whether all this new money will have the intended effect is far from clear. Many analysts see its impact as limited because consumers are struggling to deal with big debts—many owe too much on their homes to refinance, for example—and businesses may be reluctant to borrow for expansion when demand for their products remains weak.

Fed Chairman Ben S. Bernanke has acknowledged the limits and uncertainties of the central bank’s ability to lift the economy single-handedly, but as a student of the Great Depression during his years as an academic economist, he believes the government did too little then, and he apparently does not want to repeat what he seems as a costly mistake.

Bernanke’s view that more action is required is apparently shared by all but one of the members of the Fed’s policy-making committee. And that may be especially so after Tuesday’s election in which Republicans gained control of the House with a pledge to cut spending and federal tax revenues.

“We suspect fiscal policy will now be largely paralyzed for the next two years,” analysts at Capital Economics said in a research note. “The Republicans are likely to push for greater control of federal spending,” they said, adding: “The onus will be on monetary policy to support the economic recovery.”

The Fed has a dual mandate—to foster both maximum employment and price stability.

Printing billions of new dollars won’t help the situation, opponents of the new Fed effort argue, and it could backfire if a flood of cheap dollars leads to asset bubbles and flaring inflation down the road.

But unemployment has been near 9.5% for the past 17 months, and core inflation has been running at about half of the Fed’s 2% target, raising the specter of the country falling into a deflation trap—a downward spiral of prices that could undermine wages, hiring and overall economic activity.

Although the Fed expects the employment and inflation picture to improve gradually, its statement said that progress toward its objectives has been disappointingly slow.

Analysts and investors were expecting the Fed to announce a Treasury-buying program of $500 billion or more; they feared anything less than that would have jolted financial markets. Wall Street’s reaction to the news was fairly muted, although the Dow Jones industrial average ended the day higher, up 26 to close at a new two-year high of 11,215.

The stock market has been rallying in recent weeks in anticipation of the Fed announcement, and the dollar has fallen sharply since summer when Bernanke hinted that the Fed might undertake a new round of bond-buying, known technically as quantitative easing.

The weaker dollar should help American exporters as their goods will cost less in overseas markets, but the depreciating greenback has drawn criticisms from the Chinese and others who are concerned about asset bubbles and other problems caused by a flood of cheap dollars being invested in faster-growing economies.

“I’m willing to take the risk of unintended consequences,” said Diane Swonk, chief economist at Mesirow Financial in Chicago. Given the poor state of the economy and the limited policy options, she added, “I think it’s better to try and fail than not to try at all.”

At the same time, Swonk and many other economists don’t think the Fed’s new effort will give a big lift to the economy. The economy grew at a sluggish 2% annual rate in the third quarter, not enough to bring down the unemployment rate. Most are projecting similar growth for the fourth quarter and only modest improvement next year.

The Fed’s traditional method of influencing the economy is by pushing up or down the benchmark short-term interest rate that it controls. But the central bank has kept that overnight bank-lending rate near zero since late 2008. And it reaffirmed that that’s where this rate would remain for the foreseeable future.

With that tool maxed out, the Fed is now turning back to an unconventional approach that it used during the deep recession. From late 2008 to March 2010, the Fed bought $1.7 trillion of Treasury and mortgage-backed securities—an action that is widely seen as having helped to stabilize financial markets and avert an economic collapse. But with credit markets now largely healed and the economy on more solid footing—and more recent signs show incremental improvements—nobody knows what this new round of bond purchases will do.

Analysts say it will be at least a few months, possibly several years, before it’s known whether the benefits of the additional purchases outweigh the risks. “We’re in uncharted territory here,” said John Mauldin, president of Millennium Wave Advisors in Dallas. “At some point in the future, we’ll see inflation, a recovery, and they’re going to have to pull it off,” he said of the Fed removing the additional hundreds of billions it plans to inject into the financial system.

He added that the Fed’s reputation is at stake as well. “If they give all this quantitative easing and nothing happens, then their credibility—that the Fed has these powers—goes away,” he said.

One Fed board member, Kansas City Fed President Thomas M. Hoenig, would agree. He was the lone dissenter on the recent statement, concerned that the easy monetary policy “increased the risks of future financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy.”

But Bernanke and other members of the board appear to be more worried about the dangers of deflation, having seen how that cost Japan more than a decade of growth and economic progress.

“Either way, they’re in a bind,” said Jack Ablin, chief investment officer of Harris Private Bank in Chicago. “We don’t know if it’s going to work, but they’d better throw a lot of money into it.”

(c) 2010, Tribune Co.

Distributed by McClatchy-Tribune Information Services.

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