Fed primes pump as bailout skeptism rises

The central bank plans to buy as much as $300 billion in Treasury debt and purchase more mortgage-backed securities.

By , Staff writer of The Christian Science Monitor

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    Despite Fed Chairman Ben Bernanke's optimism about a future recovery, the Federal Reserve Wednesday reported further economic contraction.
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At a time when bailout fatigue appears to be setting in on Capitol Hill, the Federal Reserve is taking another big-bucks step designed to revive the economy: It will buy long-term US Treasury bonds in a bid to keep interest rates low.

The Fed’s announcement Wednesday had an immediate positive effect on bond interest rates and on the stock market. But it also put pressure on the dollar in world currency markets, with the greenback falling sharply 2 percent against the euro. Some analysts expect more decline in coming days.

What may be equal cause for concern is the circumstances within which the Fed acted. Some analysts say Fed officials are responding to a weakening outlook for the global economy and to a rising antibailout mood affecting Washington. It now looks less likely that Congress and US Treasury will pump major new money into fixing the nation’s banking system.

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“My sense is they’re doing the right thing in present circumstances,” says Desmond Lachman, a finance expert at the conservative American Enterprise Institute in Washington. “They’re hoping to bring the interest rates down” for businesses and consumers, but “we really need to fix the banking system.”

Beyond rate cuts

Since the recession began more than a year ago, the Fed has already cut its own short-term lending rate, for banks, effectively to zero.

Now, at a time when it may have hoped to pass the baton of economic-recovery policy to Congress and the Obama administration, the Fed believes its own work may be far from done.

The central bank plans to buy as much as $300 billion in Treasury debt in the next six months. The Fed also said it will expand its program of buying mortgage-backed securities, guaranteed by Fannie Mae or Freddie Mac, boosting its purchases from $475 billion to $1.25 trillion.

In addition, the Fed said it hopes to expand the scope a newly launched $1 trillion program to revive the flow of loans that are bundled into securities. The program, which provides credit to buyers of these asset-backed securities, already aims to encourage a wide range of lending, from credit cards to business and commercial real estate loans.

“The Fed is clearly being a lot more aggressive in using its balance sheet in supporting the economy,” Mr. Lachman says.

Poor outlook spurs Fed

But he says continue bad news is spurring the Fed to act.

Economic activity in Europe is declining about as fast as in the US, and in Japan the decline is much faster, he notes.

Meanwhile, in the US, the furor over bonuses at the insurance firm AIG, a major bailout recipient, may be souring an already difficult environment for Congress to consider funding an effort to clean up the banking system.

Many economists believe that until US banks have been recapitalized, and written off their losses on a rising tide of bad loans, any recovery for the economy will be difficult.

With private investors wary of investing in banks, the effort could require substantially more money from the Treasury.

Stimulus quick enough?

The Obama administration has been moving to fight the recession on several economic fronts, including a $787 billion economic stimulus spending program, a still-evolving bank-stabilization plan, and efforts to reduce home foreclosures.

But some economists, including Lachman, worry that the stimulus plan won’t kick into effect soon enough. The banking plan so far does not include new funding beyond $700 billion set aside by Congress so far.

By buying Treasury bonds, the Fed will add major demand for Treasury debt, at a time when the Treasury is expected to be issuing lots of it – to pay for that stimulus among other things.

As the rising demand pushes bonds prices up, interest rates normally move in the opposite direction. And as Treasury interest rates fall, the price of other credit for consumers and businesses could go down as well.

Between the Obama housing-market rescue program, and the Fed’s new move, many Americans could now see interest rates on home loans in below 5 percent.

The initial response the Fed’s move Wednesday was immediate and large: The yield on the 10-year Treasury note fell to 2.50 percent, from 3.01 percent late Tuesday.

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