WASHINGTON — Digging deep into its bag of leftover economic sparkplugs, the Federal Reserve on Wednesday launched an unorthodox operation aimed at lowering long-term lending rates and thus sparking more spending and investment in an economy flirting with recession.
Specifically, the Fed announced it would sell $400 billion in short-term government bonds and replace them with longer-term government bonds of equal value.
The controversial action is dubbed Operation Twist II because its patterned after a similar move in the 1960s named after the then-popular dance craze.
By the end of June 2012, the Fed intends to purchase $400 billion worth of Treasury securities with remaining maturities of six years to 30 years. In tandem, it will sell an equal amount of Treasury securities with remaining maturities of three years or less.
This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative, the Fed said in a statement at the conclusion of a two-day meeting. Three voting members dissented, arguing that the action wasn't necessary.
While financial markets had expected the move, it was accompanied by a Fed statement that noted significant risks of further economic downturn. That spooked investors, and stocks plunged. The Dow Jones Industrial Average shed 283.82 points to finish at 11,124.84. The S&P 500 was off 35.33 points to close at 1,166.76, and the NASDAQ lost 52.05 points to end at 2538.19.
Operation Twist is the right thing to do, but it won't help the economy much," said Mark Zandi, chief economist for forecaster Moodys Analytics. "Long-term rates, notably fixed-mortgage rates, are already at record lows, given investors' anticipating the Fed's actions today. But the Fed went a bit beyond expectations, and thus I think rates will go even lower. I expect 30-year fixed-mortgage rates to fall below 4 percent.
Lower lending rates might spark greater mortgage refinancing, as well as home and car sales and perhaps business investment. But, said Zandi, since rates are already so low, the boost to growth from the Fed's actions will be on the margin.
On its website, the Fed acknowledged that Operation Twist II is not a panacea, just another step that contributes to a broad easing in a number of policies taken by the Fed, the White House and Congress. It said that by driving down the interest rate paid to investors on long-term government bonds, interest rates on a range of instruments including home mortgages, corporate bonds, and loans to households and businesses will also likely be lower.
Experts warned that the realities of a weakening economy, reflected in the Fed statement, might outweigh the benefits from the new action.
This statement, with its increased assessment of downside risks, is more likely to unsettle the equity market than these twisting activities are to reassure investors, economists for forecaster RDQ Economics wrote in a research note.
The Fed indeed did paint a bleak economic landscape.
Recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated. Household spending has been increasing at only a modest pace in recent months despite some recovery in sales of motor vehicles as supply-chain disruptions eased. Investment in nonresidential structures is still weak, and the housing sector remains depressed, the statement said.
The Fed also surprised with the additional announcement that it would reinvest the principal payments it receives from its holdings of mortgage bonds — called mortgage-backed securities — into the purchase of more of these bonds. The return investors demand on mortgage bonds affects mortgage rates, and the move is designed to help keep lending rates low and spark refinancing.
The Federal Reserve, chartered by Congress early in the last century, has the dual mandate of keeping inflation low and promoting full employment. During the ongoing financial crisis, the Fed has most feared deflation, the debilitating collapse of prices across the economy.
In August 2010, the Fed began a massive purchase of government bonds to drive down lending rates and thus nudge investors to take more risks. The effort, which added a healthy dose of inflation to keep prices from declining, was called quantitative easing. Its an unorthodox way to spark economic activity when the traditional tool of lower interest rates isnt an option. The Feds benchmark lending rate has already been near zero since December 2008.
Bernankes Fed purchased $600 billion in government securities between November 2010 and June, although beginning in August 2010 it had already started reinvesting proceeds from its sale of mortgage bonds into government securities. The actions are credited with jolting U.S. stocks back to life but are also blamed for helping to drive up the price of food, oil and other commodities.
Once the purchases of government bonds ended, the U.S. economy entered a soft patch it has yet to recover from. Thats why some GOP presidential candidates such as Texas Gov. Rick Perry have criticized the Feds actions as ineffective.
GOP leaders in Congress went so far as to send Bernanke a rare letter on Monday urging him to take no further action to stimulate the economy. They said Fed actions so far had produced no clear benefits, and that more Fed actions could weaken the U.S. dollar or encourage more borrowing by over-leveraged consumers. In addition, the big-government critics voiced concern that the Fed is "vastly increasing its role in the economy."
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