WASHINGTON — Downgrading its view of the economy, the Federal Reserve on Tuesday projected a "more modest" rate of recovery in the months ahead and announced that it will use proceeds from the mortgage bonds it owns to buy new Treasury debt in an effort to spark growth and investor confidence.
The Fed's rate-setting Federal Open Market Committee left its benchmark federal funds lending rate at a range between zero and a quarter percentage point, where it's been for almost two years to lower the cost of borrowing.
That was expected. However, given a flurry of data that show the U.S. recovery beginning to lose steam, financial markets were looking for a sign that the Fed wouldn't just sit on the sidelines. So the Fed gave investors the sign they sought.
In a statement, the Fed said it would reinvest earnings from maturing mortgage debt into U.S. Treasury debt, with an eye toward keeping long-term borrowing rates low. The move aimed to reassure investors who are hoping the Fed will do more to spur the economy and observers who fear that more debt will ignite inflation.
The Fed has unleashed a wave of creative efforts over the past 23 months aimed at thawing frozen credit markets and sparking economic activity to prevent an even worse recession or even a second Great Depression.
Inflation hawks didn't want to see the Fed enlarge its portfolio of financial holdings beyond the already staggering $2.3 trillion on its books, and Tuesday they got what they wanted. The Fed's portfolio won't shrink, but it won't grow either. As old debt matures, profits from its payoff will be invested in new Treasury debt.
Likewise, financial markets wanted to see some sign that the Fed wasn't on standby as the economy slows, and reinvesting the proceeds from maturing debt assuaged them as well.
"I guess they did thread the needle," said Stuart Hoffman, the chief economist for the PNC Financial Services Group in Pittsburgh.
The Fed's new course may shave as much as a quarter-point from long-term borrowing rates, said Brian Bethune, the chief U.S. financial economist for forecaster IHS Global Insight.
"That will feed through directly to mortgage rates, which are expected to remain at historically low levels for the next several months, providing important support for the housing market," he said in a note to investors late Tuesday.
In the policy statement, Fed officials noted that "the pace of economic recovery is likely to be more modest in the near term than had been anticipated."
The Fed noted signs of forward movement in the economy, with caveats.
"Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth and tight credit. Business spending on equipment and software is rising; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls," the Fed statement said. "Housing starts remain at a depressed level. Bank lending has continued to contract."
Like the Fed, private forecasters are downgrading their expectations for the rest of this year.
"Our outlook for the second half of 2010 is for growth in the 2 percent range. Growth will be fueled by gains in equipment and software spending, while consumer spending will grow at a much slower rate than we have seen in past expansions, likely less than 2 percent. Our outlook is consistent with an economy still struggling with persistent high unemployment," John Silvia, the chief economist for Wells Fargo Securities, wrote in an analysis of the Fed action.
The Fed's decisions Tuesday weren't unanimous. Thomas Hoenig, an inflation hawk and the president of the Federal Reserve Bank of Kansas City, dissented, on the grounds that no pause was needed in shrinking the Fed's holdings.
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