Fed’s treasury-bond gambit: mother of all rescue plans
As much as $1 trillion will lower long-term loan rates like mortgages but it raises the specter of inflation.
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•Expand the types of lending it will support through an already announced program, spurring business and consumer loans by providing credit to investors who buy a range of loan-backed securities.
By becoming a huge buyer of Treasury and mortgage-agency bonds, the Fed is basically pushing the price of those bonds up. The flip-side effect is to push down the yield, or interest rate. The effect should be to lower the borrowing costs. This should be a boon for the US government, which is issuing lots of new debt as it spends to buoy the economy.
It will help home buyers and people who want to refinance mortgage loans.
“Mortgage rates now are decisively below 5 percent, and should settle somewhere between 4 and 4.5 percent,” Yardeni says, referring to cost of a benchmark 30-year fixed-rate mortgage.
The lower interest rates on Treasury bonds also help shape many other interest rates for consumers and business, so a positive ripple effect should be felt broadly through the economy.
The moves could work hand-in-hand with other policies designed to fight the recession, such as the Obama administration’s recently announced program to widen the number of at-risk homeowners who can refinance to avoid foreclosure – and an $8,000 tax credit for first-time home buyers.
Moreover, with all its bond-buying activity, the Fed is expanding the money supply at a time when many economists say that is needed. The recession, by crimping the flow of credit and economic activity, means that the so-called velocity of money – the pace at which it circulates through the economy – has slowed down.
In that environment, economists say the Fed can pump new money into the economy without fueling inflation.
Yet the central bank knows it must be careful. Massive Fed interventions raise the risk that investors will start seeing inflation on the horizon and act accordingly.
If that sentiment takes hold, it could make it hard for the Fed to achieve its objectives. Even as the Fed is buying Treasuries, private-sector investors might start selling them – both on expectations of an improving economy and of rising inflation. That could push interest rates up.
Oil prices jumped above $50 a barrel Thursday, and gold prices surged, amid a broad rally in commodities that are seen as a hedge against inflation. At a time when the US relies on foreign investors to buy many of its debts, the dollar also fell.
Desmond Lachman, an economist at the American Enterprise Institute in Washington, says that weakness in European economies should prevent a sharp slide for the dollar.
The Fed is “doing the right thing in present circumstances,” he says.