Fed takes fresh steps to support fragile recovery

Federal Reserve Board Chairman Ben Bernanke listens while he testifies before the Senate Banking, Housing and Urban Affairs Committee in a hearing on ''The Semiannual Monetary Policy Report to the Congress,'' on Capitol Hill in Washington July 21, 2010.

WASHINGTON (Reuters) - The Federal Reserve on Tuesday took a small but significant step to counter a weakening U.S. economic recovery, saying it would use cash from maturing mortgage bonds it holds to buy more government debt.

The decision to reinvest proceeds from the nearly $1.3 trillion in mortgage-linked debt, acquired during the 2008 financial crisis in an effort to keep borrowing costs down, represents a significant policy shift for the central bank.

Until recently officials had been avidly debating an exit strategy from the extraordinary monetary stimulus delivered during the financial crisis, but recent signs of weakness forced the Fed to downgrade its economic assessment.

"The pace of recovery in output and employment has slowed in recent months," the Fed said after a one-day policy meeting. In June, the Fed had described the recovery as "proceeding."

The action took investors by surprise. Many had expected the Fed to keep policy unchanged for now, and those who did expect some reinvestment of housing-linked bonds believed the funds would be directed back into mortgage securities.

Analysts said the move could herald more aggressive monetary policy easing if more signs of a slowing economic recovery emerge.

"Should the outlook continue to worsen, the Fed will likely initiate a new round of asset purchases," said Michael Gapen, economist at Barclays Capital.

U.S. stocks trimmed losses after the Fed's decision, but still closed lower on the day. Treasury debt prices rose sharply, with the yield on benchmark 10-year notes slipping to 2.77 percent, near 15-month lows. The U.S. dollar fell against both the euro and the yen.

As expected, the Fed left benchmark overnight interest rates steady in a zero to 0.25 percent range and renewed its pledge to keep them low for an extended period.

Kansas City Federal Reserve Bank President Thomas Hoenig dissented for a fifth straight meeting over the Fed's low-rate vow and said he believed the economy did not need further help.

UNEASY CHOICES

Under the new regime, the Fed will keep its holdings of domestic securities steady at around $2.054 trillion, primarily by buying government securities ranging from two to ten years in maturity.

Investors were still trying determine just how much mortgage- and housing agency-backed debt held by the Fed would be maturing each year, with estimates hovering between $100 billion and $150 billion.

While not insignificant, the amount was not generally seen as large enough to have a substantial simulative impact on the economy.

"The actual effect of what they're doing will be less powerful than the symbolic effect," said Burt White, chief investment officer at LPL Financial in Boston. "What this is telling the market is we're going to do everything and anything we can to make sure we've put a backstop on any possible risk of a double dip."

The preference for Treasuries over mortgage securities could signal a compromise with some of the more hawkish Fed officials, who have opposed policies that could favor any particular sector of the economy.

Economic data have been decidedly weak since the U.S. central bank's last meeting in late June. Consumer spending has softened and manufacturing growth appears to be losing steam. The unemployment rate, meanwhile, is stuck at 9.5 percent.

Fed officials have said there are a number of steps they could take if the recovery falters.

The Fed could lower the rate it pays banks to park their excess reserves at the central bank, currently at an already low 0.25 percent, or somehow redouble its already-stated commitment to keep interest rates low.

The central bank could also, if things got bad enough, relaunch its bond-buying program.

That policy is not without drawbacks. It could expose the Fed to charges that it is printing money to help fund the government's large budget deficit -- something Fed officials have repeatedly vowed not to do.

Some officials have been worried that the economy could fall into a deflationary cycle of falling prices and depressed consumption if activity does not pick up.

Consumer prices outside food and energy rose just 0.9 percent in the 12 months through June, holding for a third straight month at the lowest level seen since January 1966.

The fear of deflation elicits comparisons with Japan, which has long struggled with economic stagnation and falling prices.

The Bank of Japan, which also met on Tuesday, decided to hold off on any further easing measures despite a rise in the yen, which has rallied near record highs on expectations of further measures by the Fed.