Fed pays price for bond-buying program

April 26, 2011

The end is in sight for the Federal Reserve’s much-debated program of buying $600 billion in Treasury bonds to prop up the faltering economy, with the central bank’s policymakers likely to announce Wednesday that it will expire at the end of June.

The big question now: Did it work?

The answer: It depends on what you mean by “work.”

The Fed has succeeded in preventing a spiral into deflation, or falling prices, and helped avert a dip back into recession (though how real that risk was last fall can never be known for sure). It may have even contributed to the strengthening in the job market in the past few months, and almost certainly contributed to a rally in the stock market.

But the central bank, with its decision last November, also put its reputation on the line, essentially shouldering responsibility for getting the economy on track. In that sense, the Fed now owns the crummy economy in the public mind to a degree that it wouldn’t have had Chairman Ben S. Bernanke and his colleagues followed a more cautious path in setting monetary policy.

Because the payoff from the Fed’s actions has been more about what didn’t happen than what did, and the economy is still quite weak, the action put the credibility of the Fed at risk. The mixed results from the second round of quantitative easing — QE2, as it became known — could limit the Fed’s ability to take more steps to bolster growth if the economy seems poised to falter again.

“The real risk is that QE2 ends in June, and people look around and say ‘Is that all there is,’ and have this perception that monetary policy has run out of ammunition, that it’s all over, even if the economy were to roll over again,” said Vincent Reinhart, a resident fellow at the American Enterprise Institute and former senior Fed staffer.

This was an inherent risk in undertaking the bond purchase program, which was an effort by the Fed to lower the cost of money throughout the economy, boost values of stocks and other assets and lower the value of the dollar on currency markets to make U.S. exporters more competitive.

But Bernanke made it clear that the Fed's policy would be no economic panacea. “The Federal Reserve cannot solve all the economy’s problems on its own,” Bernanke wrote in a Washington Post opinion article after the November announcement.

Overall, the economy is still weak, with unemployment near 9 percent and first-quarter growth,, to be released Thursday, looking to have been weak at less than 2 percent. But some specific aims of the policy have been attained.

Investors now expect inflation to be 2.4 percent a year over the coming five years, based on prices in the bond market Tuesday. That’s well within normal historical standards and not far from the Fed’s goal for inflation to average about 2 percent. Before Bernanke raised the prospect of new bond purchases in a speech, five-year inflation expectations were as low as 1.1 percent.

When inflation is too low, it can lead consumers and investors to hoard cash rather than deploy it, and initiate a self-reinforcing pattern of falling prices, or deflation. That risk seems to have all but disappeared, and if anything the problem now is inflation, particularly with food and energy.

The other accomplishment of the Fed’s policy was to boost asset prices. The Standard & Poor’s 500-stock index is up 29 percent since its August low, and market analysts attribute the rally in large part to the Fed’s actions. By taking $600 billion in safe assets off the market by buying Treasury bonds, the central bank ensured that more money would flow into riskier assets such as stocks. That, in turn, has helped business confidence and investor wealth.

And while Bernanke avoided mentioning lowering the value of the dollar as part of his rationale — it is a political hot potato — economists widely accept that one of the ways monetary policy affects the economy is by affecting the exchange rate. The dollar is down more than 11 percent against six other major currencies since Bernanke raised the possibility of bond purchases, making U.S. exporters more competitive but contributing to the higher price of imported fuels.

The job market is improving, if only gradually, but it is less clear whether the Fed’s policies had much to do with that. The unemployment rate fell to 8.8 percent in March from 9.8 percent in November, though that is a steeper and more rapid drop than many other indicators of the labor market would suggest is truly underway.

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