Fed poised to buy more bonds to try to aid economy

[November 02, 2010]  WASHINGTON (AP) -- With unemployment at 9.6 percent, the Federal Reserve is all but certain this week to launch a new program to try to fortify the economy. Yet the program isn't expected to do much to ease a crisis that's left nearly 15 million people jobless.

On Tuesday, Chairman Ben Bernanke opens a two-day meeting where he will help craft a Fed plan to buy more government bonds. The idea is for those purchases to further drive down interest rates on mortgages and other loans. Cheaper loans might then lead people to spend more. The economy would benefit. And companies would step up hiring.

That's the plan, anyway. But many question whether the Fed's new plan will provide much benefit.

For one thing, the Fed already has driven rates to super-low levels. And anticipation of the Fed's new program has helped push down mortgage rates to their lowest points in decades. Yet the economy is still struggling.

The Fed has tried since the 2008 financial crisis to keep credit available to individuals and businesses. It's done so, in part, by keeping the target range for its bank lending rate near zero.

It also pursued the unorthodox strategy of buying long-term bonds. The Fed's purchases are so vast that they push down the rates on those bonds.

In 2009, with nation deep in recession, the Fed aggressively bought $1.7 trillion in mortgage and Treasury bonds. Those purchases helped lower long-term rates on home and corporate loans.

The Fed's aid program this time is likely to be smaller -- $300 billion to $500 billion -- and more gradual. In part, that's because the economy is in better shape now.

A smaller program will also be less objectionable to some Fed officials. They fret that further lowering interest rates poses long-term risks -- namely runaway inflation.

"Bernanke is trying to strike a balance," said Lou Crandall, chief economist at Wrightson ICAP.

It's a gamble, though.

Americans so far have resisted ramping up spending as they usually do after recessions. Instead, many are working to repair their finances. They are trimming debt, rebuilding savings and trying to restore their credit.

A bond-buying program of around $500 billion would likely provide only a modest boost to growth in the current fourth quarter of the year. Even with it, the unemployment rate is expected to stay above 9 percent by year's end.

One option is for the Fed to announce its intention to buy a specific amount in bonds -- say $500 billion -- over a set number of months. After that, it would assess, at each meeting, whether it should buy more. Its decision would hinge on how the economy is faring.

The Fed will announce its purchases Wednesday, one day after the nation votes for a new Congress. High unemployment, meager wage gains and soaring home foreclosures have frustrated many voters. Republicans are expected to score big gains.

Wall Street investors and many economists are anticipating that the Fed will settle on $500 billion in bond purchases. Anything less could disappoint bond and stock traders, send interest rates up and stock prices down.

William Dudley, president of the Federal Reserve Bank of New York, estimates that a $500 billion purchase program would provide about as much stimulus as a cut of one-half to three-quarters of a point in the Fed's main interest-rate lever. That's the federal funds rate.

That rate is already at a record low near zero. That's why the Fed is turning to unconventional methods to try to energize the economy.

Here's how the plan would work:

As the Fed buys Treasurys, the rates on those bonds will fall. It's supply and demand: Higher demand for bonds lowers their rates, or yields. Rates on mortgages, corporate debt and other loans pegged to the Treasurys would drop, too.

But the Fed's expected move has sharply divided economists, according to an AP Economy Survey released last week. Roughly half said such bond purchases, if they reduced rates, could spur Americans to spend more, strengthen the economy and lead to more hiring.

But the other half countered that another round of stimulus won't provide much help. Some worry it could lead to new threats later on. These include out-of-control inflation or a wave of speculative buying that inflates bubbles in the prices of commodities or bonds or other assets.

More than a year after the recession ended, the economy has failed to generate a robust rebound. The economy did grow slightly faster last summer as Americans spent a bit more, the government said Friday. But it wasn't nearly enough to lower unemployment.

The jobless rate stands at 9.6 percent. It's been at least 9.5 percent for 14 months, the longest stretch since the Great Depression.

The "slack" in the economy -- factories running below capacity and companies limiting hiring -- has kept inflation historically low. In the 12 months that ended in September, consumer prices rose just 1.1 percent.

Bernanke has said the Fed would like to see inflation closer to 2 percent to show the economy is making a solid recovery. The Fed will likely signal in its policy statement after the meeting that it favors slightly higher inflation. But analysts think it will probably stop short of mandating an explicit inflation target of 2 percent or higher.

Bernanke doesn't want to see super-low inflation turn into deflation. That's a widespread drop in prices, wages and the values of homes and stocks.

Deflation can cause people to delay purchases because they feel they can buy later at lower prices. Falling incomes also make it harder to pay debts. Foreclosures rise. So do bankruptcies. Once it takes hold, deflation is hard for policymakers to break. Deflation contributed to Japan's "lost decade" of the 1990s, and the country is still battling it.

The notion of letting inflation run higher makes some Fed members queasy.

Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, and other "inflation hawks" argue that another round of Fed action could lead to too-high inflation and new speculative asset bubbles. At each meeting this year, Hoenig has opposed the Fed's pledges to keep rates at record lows and other efforts to energize the economy. He's likely to oppose the new aid program.

While Fed officials acknowledge that the risk of deflation is small, an outbreak could be devastating. That's another reason Bernanke wants to launch the new aid program. It would help blunt any deflationary trends.

"Bernanke knows the lessons of Japan and the Fed's own mistakes in the 1930s," said Randall Kroszner, a former Fed governor. "He doesn't want to repeat them."

[Associated Press; JEANNINE AVERSA]

Copyright 2010 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.