Fed takes bold, risky step to bolster weak economy

WASHINGTON Thu Nov 4, 2010 10:35am EDT

Traders in the 30-year bond options pit at the Chicago Board of Trade signal orders shortly after the Federal Reserve's decision to leave short-term interest rates untouched, November 3, 2010. REUTERS/Frank Polich

Traders in the 30-year bond options pit at the Chicago Board of Trade signal orders shortly after the Federal Reserve's decision to leave short-term interest rates untouched, November 3, 2010.

Credit: Reuters/Frank Polich

Related Video

Related Topics

WASHINGTON (Reuters) - The Federal Reserve launched a fresh effort to support a struggling U.S. economy on Wednesday, committing to buy $600 billion in government bonds despite concerns the program could do more harm than good.

The decision takes the Fed into largely uncharted waters and is aimed at further lowering borrowing costs for consumers and businesses still suffering in the aftermath of the worst recession since the Great Depression.

The U.S. central bank said it would buy about $75 billion in longer-term Treasury bonds per month through the end of June 2011 and could adjust purchases depending on the strength of the recovery.

"The economy is slowly digging itself out of a deep hole," said Brian Bethune, economist at IHS Global Insight in Lexington, Massachusetts. "The Fed is making the right moves here to nudge the pace up a little," he said.

Critics within and outside the central bank fear the Fed's policy will lead to high inflation and worry that low interest rates in the United States risk fueling asset bubbles in other countries and destabilizing currencies.

But with the U.S. economy expanding at only a 2.0 percent annual pace in the third quarter of this year and the jobless rate seemingly stuck around 9.6 percent, the Fed had come under pressure to do more to stimulate business activity. HIGH

UNEMPLOYMENT, LOW INFLATION

In the Fed's post-meeting statement, policymakers described the economy as "slow" and said employers remained reluctant to create jobs. They also called inflation "somewhat low."

"Progress toward (our) objectives has been disappointingly slow," the Fed said, referring to its dual mandate to maintain price stability and foster maximum sustainable employment.

Still, these domestic goals appeared to be creating troubles abroad. The prospect of ultra-low returns in the United States have driven investors into higher-yielding emerging markets, pushing those currencies higher and sparking anxiety over a loss of export competitiveness.

"We are all under attack by the relaxed monetary policy of the United States," Colombian Finance Minister Juan Carlos Echeverry told investors on Tuesday.

With 14.8 million Americans unemployed, factories operating well short of capacity, and inflation well below the range the Fed would prefer, some officials at the central bank see the risk of a vicious deflationary cycle where consumers hold off on purchases, choking off economic growth.

Fed Chairman Ben Bernanke, in an opinion piece posted on the Washington Post's web site on Wednesday, said policymakers could not sit idly by given the anemic economic backdrop. He argued that fears that unconventional monetary policy would spark a future bout of inflation were "overstated."

"Inflation that is too low can pose risks to the economy -- especially when the economy is struggling. In the most extreme case, very low inflation can morph into deflation, which can contribute to long periods of economic stagnation," Bernanke wrote.

MARKET REACTION SUBDUED

The overall size of the bond buying program was slightly larger than the $500 billion that many analysts had looked for, though the pace of monthly buying fell short of expectations for something around $100 billion.

Market reaction was initially volatile but at the end of the day left the recent uptrend in stocks and downtrend in the U.S. dollar intact.

The Standard & Poor's 500 index of U.S. stocks rose just 0.37 percent after initial losses and the dollar fell against the euro. U.S. Treasury bond yields fell for shorter-dated maturities. Disappointment that the Fed did not expand buying to 30-year bonds led to a sharp rise in long-dated yields.

While doubts lingered about the ability of bond purchases to kick start a moribund economy, there was a sense in the market that the Fed was open to doing more if the recovery remains sluggish.

"The (Fed) is still leaning toward the easier side and views the program as being open-ended," said Ward McCarthy, chief financial economist at Jefferies in New York.

Nearly 90 percent of the Fed's purchases will be of Treasuries with maturities ranging from 2- to 10 years, the New York Fed said, adding it would temporarily relax a rule limiting ownership by the Fed of any particular security to 35 percent. It said holdings would be allowed to rise above that threshold "only in modest increments."

BUY AMERICAN (BONDS)

In response to the most severe financial crisis in generations, the central bank had already cut overnight interest rates to near zero and bought about $1.7 trillion in U.S. government debt and mortgage-linked bonds.

Those purchases, however, occurred when financial markets were largely paralyzed, and economists and Fed officials alike are divided over how effective the new program will be.

Indeed, Kansas City Fed President Thomas Hoenig and some other Fed officials worry further bond buying could do more harm than good by providing tinder for inflation that will ignite when the recovery finally gains traction. Hoenig voted against the action, his seventh straight dissent.

The Bank of Japan, which meets on Thursday and Friday, is also poised to launch a new round of bond buying. The European Central Bank and Bank of England also meet this week, but are expected to leave policy on hold.

The Fed's policies have repercussions for liquidity in Treasury bonds, the world's largest sovereign debt market where investors historically seek safe-haven from market stress.

The U.S. central bank already owns roughly 12.5 percent of all outstanding Treasury bonds and notes. If it were to buy $1 trillion more, as some economists expect it eventually will, the portion of its holdings compared with all outstanding Treasuries could jump to 27 percent.

A group of bond dealers that advises the U.S. Treasury expressed concerns about the possibility that a shortage of bonds could cause market disruptions, according to minutes from its November 2 meeting released on Wednesday.

(Additional reporting by Emily Kaiser)

FILED UNDER:

Recommended Newsletters

Reuters U.S. Top News
A quick-fix on the day's news published with Reuters videos and award-winning news photography and delivered at your choice of one of four times during the day.
Reuters Deals Today
The latest Reuters articles on M&A, IPOs, private equity, hedge funds and regulatory updates delivered to your inbox each day.
Reuters Technology Report
Your daily briefing on the latest tech developments from around the world from Reuters expert tech correspondents.