Fed takes new tack to avoid U.S. economic slump

WASHINGTON (Reuters) - The Federal Reserve on Wednesday warned of significant risks to the already weak U.S. economy and launched a new plan to lower long-term borrowing costs and bolster the battered housing market.

The U.S. central bank said it would sell $400 billion of short-term Treasury bonds to buy the same amount of longer-term U.S. government debt, its latest attempt to kickstart growth that slowed to a crawl over the first half of the year.

Apparently spooked by the central bank's dismal outlook for the economy, U.S. stocks sold off. The Standard & Poor's 500 index closed down nearly 3 percent.

Prices for long-term government debt rose, pushing yields lower -- a sign the measures were more aggressive than some investors had expected. The yield on the benchmark 10-year note dropped as low as 1.856 percent, the lowest in more than 60 years.

"Recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated," the Fed said in a statement after a two-day meeting. "There are significant downside risks to the economic outlook, including strains in global financial markets."

In offering a fresh approach to spur the economy and lower unemployment, the Fed ignored top Republicans on Capitol Hill who had pressed the central bank to refrain from action.

In addition to rebalancing its portfolio, the Fed intensified its efforts to shore up the housing market by pledging to reinvest proceeds from maturing housing-related debt it holds back into the mortgage market.

Analysts said the Fed's actions might not have a great impact, even if they did lower long-term interest rates.

"The cost of borrowing simply isn't the problem," said Paul Ashworth, an economist at Capital Economics in Toronto. "Businesses don't have the confidence to invest and half of all mortgage borrowers don't have the home equity needed to refinance at lower rates."

Still, faced with a lofty 9.1 percent jobless rate and an escalating sovereign debt crisis in Europe, Fed officials felt they needed to do what they could to try to breathe more life into the sluggish U.S. recovery.

The economy grew at less than a 1 percent annual rate over the first half of the year and analysts have warned of a heightened risk of recession.

With Fed Chairman Ben Bernanke reluctant to stay on the sidelines, his activism has become a punching bag for politicians as an election year nears. Top Republican lawmakers wrote to Bernanke this week urging the central bank to resist further economic interventions, echoing criticism voiced by Republican presidential candidates.

The portfolio retooling plan stops short of an outright expansion of the Fed's holdings -- sometimes referred to as quantitative easing -- of the type that has drawn harsh criticism domestically and internationally for sowing the seeds of inflation and debasing the dollar.

Some analysts however expect the move will be one in a series of steps the Fed takes to help the economy. The Fed could cut the rate it pays banks for reserves parked at the central bank, which might free up lending, or promise not to raise rates until unemployment drops to a certain level.

By shifting its bond holdings into longer maturities, the Fed is trying to push long-term interest rates lower, which hopefully will spur mortgage refinancing and borrowing by businesses and consumers.

Not all policymakers were on board with the Fed's latest move. The same three officials that had dissented against a decision in August to bolster a low interest rate pledge also opposed Wednesday's move.

Mohamed El-Erian, co-chief investment officer at PIMCO, the world's biggest bond fund, said the combination of dissents and a gloomier outlook pointed to a growing policy divide.

IN GOOD COMPANY

The central bank said it will buy $400 billion in securities with maturities of six to 30 years by the end of June 2012, selling an equal amount of debt maturing in three years or less.

The Fed is not alone in its concerns. The Bank of England on Wednesday indicated it was ready to pump more money into the weakening British economy. Norway's central bank signaled it might refrain from rate increases for longer than previously expected.

The Fed had already embarked far down one of the most aggressive monetary easing paths on record. It cut overnight interest rates to near zero in December 2008 and then moved to more than triple its balance sheet through a series of bond purchases.

After its last meeting on August 9, the Fed said it expected to hold rates at rock-bottom levels at least until the middle of 2013, drawing the trio of dissents.

Critics claim the monetary easing campaign has failed to produce results and warn it could actually cause damage by fueling inflation and debasing the dollar.

"We have serious concerns that further intervention by the Federal Reserve could exacerbate current problems or further harm the U.S. economy," Republican congressional leaders said in their letter to Bernanke, which they released on Tuesday.

The central bank's policies have also become a topic on the presidential campaign trail. Texas Governor Rick Perry, a leading Republican candidate, said any further Fed money printing would be almost "treasonous."

(Additional reporting by Jason Lange and David Lawder in Washington; Editing by Tim Ahmann and Andrew Hay)