WASHINGTON — The Federal Reserve embarked on a historic intervention in bond markets Wednesday, announcing the staggered purchase of $600 billion in Treasury bonds through next June in an effort to spur greater investment, risk taking and activity in the moribund U.S. economy.
The rate-setting Federal Open Market Committee concluded a two-day meeting with a statement that outlined its aggressive new approach to lower long-term lending rates across the economy. The Fed also said it would reinvest earnings from previously purchased debt, raising its total sum of coming action to a range as high as $900 billion.
Since such a big purchase of Treasury bonds by the central bank never has been tried before, it's effect, both intended and unintended, is largely unknown. Among the risks are a return of hard-to-control inflation, a weakening of the dollar versus other currencies and higher prices for oil and other commodities if the dollar sags.
The Fed's benchmark federal funds rate, which influences a wide range of borrowing rates, has been near zero since 2008. Unable to cut rates any further, the Fed is trying new steps to spur the economy.
"To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the committee decided today to expand its holdings of securities," the Fed said.
The Fed will purchase the Treasury bonds at a pace of about $75 billion a month through next June, to a total of $600 billion, higher than the $500 billion expected. In purchasing government bonds, the Fed hopes to drive down their yields, or return to bondholders. That, in turn, would drive down what borrowers pay on lending rates influenced by these instruments of government debt. For consumers, loans to buy a car or house could become cheaper; for businesses, loans for equipment purchases could, too.
Wednesday marked the Fed's second attempt at what's called quantitative easing. It purchased $1.75 trillion in mortgage bonds from 2008 through last March, following the financial crisis of 2008. That came at a time when credit markets had seized up and the Fed single handedly kept mortgage finance afloat with its bold action.
This latest effort, dubbed QE2 by analysts, occurs as financial markets have largely recovered, so it won't carry as big a punch as the earlier one.
The move has its critics, and even the Fed itself isn't unanimous.
"We think that QE2 will provide little benefit to the economy but will further undermine the dollar and boost gold and commodity prices over the coming months. We entirely agree with Kansas City Fed President Hoenig's dissent," said New York forecaster RDQ Economics, in a research note. "Hoenig worries about the impact on financial stability and longer-term inflation risks from further quantitative easing. The rest of the voting members of the FOMC, however, seem able to drink the quantitative easing Kool-Aid."
Brian Bethune, the chief U.S. financial economist for forecaster IHS Global Insight, took the opposite view.
"The economy is slowing digging itself out of a deep hole. The Fed is making the right moves here to nudge the pace of digging up a little to the point where we might start to see a few flickers of light at the end of the tunnel," Bethune said in a research note.
Still other analysts think the Fed can thread the needle.
"Going forward, the Fed will certainly accept higher inflation, faster growth in the short-run and expect that over time, policy can reverse fast enough to avoid an inflationary spike. Our concern remains that any potential pick-up in inflation coupled with a declining dollar and rising interest rates could be adverse enough to put many investors with three percent or less fixed-income assets under water very quickly, and not everyone can get through the door at the same time," John Silvia, the chief economist for Wells Fargo Securities, said in a research note.
Some prominent economists such as former Fed Vice Chairman Laurence Meyer have warned that to be effective, the Fed would have to purchase perhaps $5 trillion in government bonds. That would create economic stimulation equivalent to a steep cut in interest rates, in the range of 4.25 percentage points.
The Fed is unlikely to consider such huge sums, however, especially now that voters this week sent a message to Washington about cutting spending and debt. With Congress and the president unlikely to gin up spending directly, Fed leaders left the door open for more purchases of government bonds.
"The committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability," the Fed statement said.
Analysts such as former Fed governor Lyle Gramley estimate that the action could add as much as half a percentage point of growth to the economy. That's helpful in a sluggish environment but not enough to spark the economy roaring back to life.
Even so, the Fed feels compelled to act as it confronts substantial headwinds.
"Many challenges of (conducting) monetary policy are impeded right now. You're not going to get much traction in housing, you're not going to get much more lending, you're not going to get businesses to invest more, they're already sitting on a lot of cash," said Vincent Reinhart, a former top FOMC economist and now a scholar at the American Enterprise Institute, a conservative think tank.
Few Fed moves have been signaled as far in advance as this one — since August in this case — or provoked so much public discussion by Fed officials.
There was only one vote against the unorthodox plan from Fed Chairman Ben Bernanke, and that came from Federal Reserve Bank of Kansas City President Thomas Hoenig. He's been the lone dissenter in previous Fed moves to keep interest rates at their historically low level or near zero since 2008.
"Mr. Hoenig believed the risks of additional securities purchases outweighed the benefits. Mr. Hoenig also was concerned that this continued high level of monetary accommodation increased the risks of future financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy," the Fed statement said.
Three other Fed presidents have expressed doubts about the utility of the bond purchases, and they will be rotating onto the Open-Market Committee next year. They are Dallas Fed President Richard Fisher, Minneapolis Fed President Narayana Kocherlakota and Philadelphia Fed President Charles Plosser.
What Hoenig and some prominent investors fear is that it may be hard to raise interest rates later after inflation — rising prices across the economy — grows to worrisome levels. The normal response to inflation is to raise interest rates to cool economic activity, but that may prove politically difficult.
"The biggest risk is inflation down the road," Bill Gross, the managing director of PIMCO, the world's largest bond fund, said on CNBC television.
The Fed's action Wednesday suggests that it sees a greater threat from deflation, or the collapse of prices across the economy.
Before becoming Fed chairman, Bernanke was the nation's leading academic expert on the Great Depression. He's regularly warned that failure to act aggressively in that era prolonged the deep economic funk. He's shown himself keen to avoid that failure, as Wednesday's unusual move underscores.
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