By Neil Irwin
Washington Post Staff Writer
Friday, October 15, 2010; 10:34 PM
BOSTON - Federal Reserve Chairman Ben S. Bernanke sent a strong signal Friday that the central bank is gearing up for a major new attempt to jolt an economy that is at risk of getting stuck in an entrenched pattern of sluggish growth.
With little prospect of new fiscal stimulus from Congress and the unemployment rate near 10 percent, new Fed efforts to pump hundreds of billions of dollars into the economy by buying Treasury bonds may be the best remaining hope for stronger growth. But the Fed's actions may have only a modest impact and could create all manner of risks for the economy.
Increased expectations that the Fed will act have driven financial markets upward. The stock market, as measured by the Standard & Poor's 500-stock index, is up 9 percent since Sept. 1, following a late-August speech by Bernanke indicating the central bank's readiness to intervene should economic conditions warrant.
If the Fed essentially prints money to buy bonds, as it is considering, it would help the economy by lowering long-term interest rates for home mortgages, corporate loans and other forms of lending. Forecasting firm Macroeconomic Advisers estimates that $400 billion in bond purchases would drive interest rates on 10-year loans down by 0.13 percentage points.
While financial markets have reacted enthusiastically to the possible infusion of money from the Fed, the economy itself remains on uneven footing, giving off mixed signals. On Thursday, the government reported that trade was a greater drain on economic activity in August than previously thought, and on Friday there was positive new evidence on retail sales, which rose 0.6 percent in September, the Commerce Department said.
The budget deficit was $1.29 trillion in the fiscal year ended Sept. 30, the government said Friday, the second largest shortfall relative to the size of the economy since World War II. The 2009 fiscal year budget deficit was larger, both in absolute terms (at $1.4 trillion) and relative to the size of the economy. The lower deficit was due to higher tax revenue generated by the somewhat improved economy and lower costs from the financial bailout and other emergency measures.
Inflation remains exceptionally low, which Bernanke characterized as the major reason the Fed may take new action. The Labor Department said that consumer prices rose only 1.1 percent over the past year, or 0.8 percent when the volatile food and energy segments are excluded.
The news on consumer prices was followed Friday by an announcement from the Social Security Administration that recipients of the government social insurance program will not get a cost-of-living increase in 2011, the second year in a row. Federal rules say that consumer prices must rise past their level when the last Social Security increase was awarded for higher benefits to take effect. The last price increase was in 2008, and Friday's numbers did not surpass that.
Bernanke said Friday that the Fed aims for inflation to be "about 2 percent or a bit below" and that "[in] effect, inflation is running at rates that are too low relative to the levels" that Fed policymakers think appropriate in the longer run.
He told an audience of economists and central bankers at a conference at the Federal Reserve Bank of Boston that the Fed "is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation over time to levels consistent with our mandate."
The central bank's policymaking committee meets Nov. 2-3, and analysts now consider it highly likely that a massive new bond purchase program will be announced after that meeting. The exact size and pacing of those purchases is unknown, and Bernanke gave few hints in his speech.
Indeed, expectations have grown so large in the financial world that there could be an adverse reaction in stock and bond markets even if the Fed announces a sizable program then.
"A large amount of Treasury purchases seems to be priced into the markets," said Dean Maki, chief economist at Barclays Capital. "So at this point, if they come out with a small number, the markets would be disappointed."
The peril of triggering a negative reaction in financial markets is just one risk the Fed will face if it launches a new program. Others include the possibility of a rapid decline in the value of the dollar relative to other world currencies or a loss of inflation-fighting credibility for the Fed. Then there is the basic concern that the action may not do much to reverse an economy that is growing too slowly to create many jobs.
Bernanke did address the risks and trade-offs of buying bonds, but he did not characterize them as so substantial as to eliminate the case for new action.
"There would appear - all else being equal - to be a case for further action," Bernanke said. "But nonconventional policies have costs and limitations that must be taken into account in judging whether and how aggressively they should be used."
The speech amounted to a methodical explanation of the reasoning for potential new monetary easing, including sharing a subdued view of the economic outlook.
"Growth next year seems unlikely to be much above its longer term trend," he said, which would mean that "job creation may not exceed by much the increase in the size of the labor force, implying that the unemployment rate will decline only slowly."