November 3, 2010 / 4:29 AM / 9 years ago

Fed takes bold step to bolster economy

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

United States dollar banknotes are seen at the Museum of American Finance in New York October 15, 2010. REUTERS/Shannon Stapleton

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 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...”

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 abroad.

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.


In the Federal Reserve’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.

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.

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 2-1/2 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.”


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 impact of Fed monetary easing overseas has been significant. With the prospect of a long period of ultra-low returns in the United States, investors have flocked to emerging markets, pushing those currencies higher. Developing economies, worried about a loss of export competitiveness, have cried foul.

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

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 also 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

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