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Federal Reserve to buy U.S. debt, shifts policies as recovery slows

By Neil Irwin
Washington Post Staff Writer
Wednesday, August 11, 2010; A01

With the recovery losing momentum, the Federal Reserve moved Tuesday to try to boost growth, an about-face by a central bank that has spent most of the last year winding down its aggressive measures to support the economy.

The Fed pledged to keep the amount of assets it holds unchanged at $2 trillion rather than allow the level to taper off over time. The decision should help keep long-term interest rates, such as those for home mortgages and corporate loans, a bit lower than they otherwise might have been, though the direct economic impact is likely to be modest.

The bigger significance of the decision is what it signals about Fed officials' view of the economy, and about their willingness -- and ability -- to go further if conditions worsen.

Fed leaders are starting to grapple with the risk that the recovery could stall altogether and that prices could even begin falling. In a deflationary spiral, like the one experienced by Japan in the 1990s, falling prices lead people to hoard cash, which weakens the economy further, and debts become even more onerous.

Most Fed leaders have said that is unlikely to happen in the United States. The officials, however, did say after their meeting that the "pace of recovery in output and employment has slowed in recent months." They added that the pace of the expansion "is likely to be more modest in the near term than had been anticipated."

The central bank, as is its practice, released only a short, carefully worded statement announcing the results of its policymaking meeting Tuesday, and committee members do not comment publicly. But economists, analysts and investors who parsed the statement found ample evidence of a central bank more attuned to the risks of a slowing economy.

The immediate impact of the Fed's policy change was limited; interest rates on benchmark Treasury bonds declined a mere 0.07 percentage points.

"The signaling effect is much greater than the actual effect," said Anthony Chan, chief economist at J.P. Morgan Private Wealth Management. "It says that they have a lot more firepower to deploy if it becomes necessary."

The Fed is essentially saying that if the economy were to deteriorate and a return to recession appeared imminent, the central bank would react by resuming its purchases of long-term Treasury bonds -- not just buying enough to replace the mortgage securities it holds as they mature, but actually increasing its total holdings.

The Fed is able to pump money into the economy by buying bonds -- in effect, it creates money out of thin air and uses it to pay investors for the bonds. This helps push interest rates down, which should make it cheaper for Americans to consume and invest. However, if Americans lack confidence in the future, low interest rates may not be enough.

"They've provided some reassurance for the frazzled nerves of investors, consumers and businesses that they're taking the evidence of a slowing economy seriously," said Bruce McCain, chief investment strategist at Key Private Bank.

The Fed now holds $1.4 trillion in mortgage-related securities. Under its previous policy, the central bank did not intend to replace any of those securities once the underlying mortgages were paid off, such as when people refinance their homes.

As a result, the size of the Fed's balance sheet was on track to shrink by $200 billion or so over the coming year, due to the routine maturing of those securities. Indeed, record-low interest rates have encouraged large numbers of people to refinance their homes, which meant that the Fed's support for economic growth was waning.

The action announced Tuesday was meant to stop that.

Fed officials' decision to replace maturing mortgage securities specifically with Treasury bonds instead of with more mortgage securities also marked a policy shift. If the Fed had continued investing in mortgage securities, that might have benefited the housing market directly by keeping mortgage rates low. The mortgage market is now functioning reasonably well, though, with very low rates relative to Treasury bonds, and Fed leaders say they prefer not to pursue policies that favor one sector, in this case housing, over others.

Still, buying more Treasury bonds has its own pitfalls. In effect, the Fed will be printing money to fund U.S. budget shortfalls, which could fuel fears that the central bank is making it easier for Congress and the president to continue running large deficits. That in turn poses the threat of inflation getting out of control.

As it has at every meeting since December 2008, the Federal Open Market Committee, which is central bank's policymaking arm, elected to keep its target for short-term interest rates near zero and pledged that rates would remain there for an "extended period." Fed leaders did not take any other steps to support growth, such as adding to the securities on its balance sheet or strengthening a previous pledge to keep rates extremely low for an "extended period."

Thomas M. Hoenig, president of the Federal Reserve Bank of Kansas City, dissented from the decision, as he has at every meeting this year, preferring not to retain the "extended period" pledge nor to resume purchases of securities.

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