Federal Reserve to buy $600 billion in bonds as hedge against deflation

The Federal Reserve hopes its Treasury bond buy will boost economic grown and inflation. Critics say it will raise prices and do little to help the economy.

Frank Polich/Reuters
A bond trader at the Chicago Board of Trade shortly after the Federal Reserve's decision Wednesday to leave short-term interest rates untouched.

The Federal Reserve is trying to take out an insurance policy against the risk of deflation and a return to recession.

The price tag for that insurance: $600 billion.

That's the amount the Fed said Wednesday that it will spend over the next eight months to buy US Treasury bonds. The idea is to pump new money into a weak economy, boosting both economic growth and inflation.

Many economists expect the new policy to have a modestly positive effect on the economy, but critics say it will spark an unwelcome level of inflation without creating jobs. Reaction in the stock and bond markets Wednesday afternoon was muted, because the Fed had telegraphed its move in public statements over the past few weeks.

The central bank's policymaking committee, led by Fed Chairman Ben Bernanke, voted 10-to-1 to take new action. The bank's mandate from Congress is to seek both full employment and a stable overall price level, and the Fed said that "progress toward its objectives has been disappointingly slow."

In its statement, the Fed's policy committee said it plans to buy about $75 billion of long-term Treasury securities per month. The goal is "to promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate."

The Fed's monthly purchase amounts are relatively modest, not a policy of shock and awe. The downside, for ordinary Americans, is that the policy may not provide a huge boost to growth. On the positive side, the move's modest scale shields the economy somewhat from the inflation risks that critics see in the plan.

How is it intended to work?

Economists at the investment bank Morgan Stanley, in a note to clients Wednesday, cited several channels by which the Fed's policy may help lift growth. The Fed begins by using its power to create money, and using it to buy bonds. Pumping new money into the economy can push up the price of assets (such as corporate stocks), lower the dollar's exchange rate (making US exports more attractive), and raise inflation expectations (thus reducing real interest rates).

"All this has already happened this time around in anticipation of the [Fed's] decision," the economists at Morgan Stanley write. "Unless markets reverse suddenly to undo the financial easing, demand [in the economy] should respond positively."

This policy of so-called "quantitative easing" has worked in the US and other nations before, they add. It's considered an unconventional policy, however, because central banks use official interest-rate cuts as their preferred policy tool. (Today the Fed's short-term interest rate is at about zero percent, and may stay there until the economy improves substantially.)

Potentially, the asset-purchase policy could also help to revive bank lending by expanding the nation's money supply. The risk is that it could stir up inflationary pressures, or leave the Fed with a difficult juggling act when the time comes to reduce the size of its balance sheet by selling bonds.

By printing more money, the Fed could work against its own goal of boosting the economy, critics warn. Inflation and expectations of future inflation could push up long-term interest rates, they say.

Another risk is that the influx of monetary stimulus could fuel an asset-price bubble – with unhappy consequences when it bursts. Currently, a declining dollar and low US interest rates are pushing investors toward assets in emerging-market nations.

For now, US inflation is nearly nonexistent in the overall consumer price index, although prices of commodities such as oil have been rising. The Fed views falling prices, including of assets such as houses and stocks, as something that could harm the economic recovery by making consumers less likely to spend.

The Fed's policy committee says it will review and adjust its bond-buying policy based on economic conditions.

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