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Fed to buy $600 billion in T-bonds to prod economic growth

Fed policymakers aim to drive down long-term interest rates to spur more home refinancing and consumer and business spending and encourage companies to begin hiring.

November 04, 2010|By Don Lee, Los Angeles Times

Reporting from Washington — A day after congressional elections that repudiated President Obama and slammed the door on any new economic stimulus, the Federal Reserve stepped in with a controversial 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 hope of encouraging more spending and borrowing by both 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. And Fed officials left open the possibility of upping the ante, depending on evolving economic conditions.

Whether all this new money will have the intended effects is far from clear. Many analysts see its effect as limited. For example, the availability of cheap credit should encourage more homeowners to refinance their mortgages. But many homeowners are "underwater" — they owe more on their mortgages than their homes are worth — and can't take advantage of low rates.

Businesses, meanwhile, 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 that the biggest mistake the government can make is to not do everything it can to fuel spending.

Bernanke's role has taken on added significance in the wake of Tuesday's midterm elections, 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.... The onus will be on [the Fed's] monetary policy to support the economic recovery."

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

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

But unemployment has been at or above 9.5% for the last 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, it stated Wednesday 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: The Dow Jones industrial average rose a modest 26 points, enough to reach 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 central bank might undertake a new round of bond buying, known technically as quantitative easing.

The weaker dollar should help American exporters because their goods will cost less in overseas markets. But the depreciating greenback has drawn criticism from China and other nations that 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 said, "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 economic recovery. The economy grew at a sluggish 2% annual rate in the third quarter, not enough to bring down the unemployment rate. Most economists are projecting similar growth for the fourth quarter and only modest improvement next year.

The Fed's conventional method of influencing the economy is to push 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 Wednesday that the rate would remain at that level for the foreseeable future.

With that tool maxed out, the Fed is turning back to an unconventional approach that it used during the deep recession.

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