Fed plan for short-term fix brings long-term risks

[October 16, 2010]  WASHINGTON (AP) -- Federal Reserve Chairman Ben Bernanke is balancing a short-term fix for the economy with a long-term gamble: His plan to buy Treasury bonds to fight high unemployment and super-low inflation now could ignite inflation later.

But Bernanke is signaling that doing nothing would pose the biggest risk of all.

The Fed chief on Friday made his strongest case yet for injecting billions more dollars into the economy. Purchasing the bonds could further drive down rates on mortgages, corporate debt and other loans.

Lower rates could lead people and companies to borrow and spend. And higher spending might help ease unemployment and invigorate the economy.

The Treasury purchases would have another aim, too: to dispel any notion that consumer prices will stay flat and might even fall. In his speech Friday in Boston, Bernanke indicated that Fed policymakers favor raising inflation, which has all but vanished.

And more inflation could help the economy. Here's how:

Companies would feel more inclined to increase prices. And shoppers who thought prices were headed up would be more likely to buy now rather than wait. Their higher spending could embolden employers to step up hiring. It would also help lift inflation.

But overhanging the Fed's plan is the risk that it would trigger runaway inflation months or years from now.

Once investors began to fear approaching inflation, they would demand higher rates on bonds. Banks, too, would raise loan rates to compensate for the higher inflation they expect. Workers would demand higher pay. Any strength the economy had managed to gather could dissolve.

Bernanke made clear he's mindful of the gamble. But he also indicated he feels that short-term needs take priority.

"There would appear -- all else being equal -- to be a case for further action," Bernanke said, building on the case he first laid out in an August speech in Jackson Hole, Wyo.

The Fed is returning to unorthodox steps like buying government bonds to aid the economy because it's already sliced its key interest rate to a record low near zero.

Some economists say the Treasury purchases might not work because interest rates already are so low that the benefit of driving them lower would be scant. And lower rates won't help if businesses and individuals can't afford to borrow, don't want to borrow or cannot qualify for loans.

To buy Treasury debt, the Fed in effect prints money. As the Fed snaps up Treasury bonds, the rates on those bonds will fall. Rates on mortgages, corporate debt and other loans pegged to Treasury securities will drop, too.

It comes down to supply and demand: Higher demand for bonds lowers their rates, or yields. And it drives up their prices.

Fed policymakers are expected to announce their Treasury buying program at their next meeting Nov. 2-3. Bernanke indicated that a big issue remains unresolved: How big should the Treasury purchases be and how fast should they be carried out?

During the recession, the Fed launched a $1.7 trillion program of buying mortgage securities and government debt. That effort was credited with forcing down mortgages rates, which helped prop up the housing market. The Fed's new program is likely to be much smaller. One Fed official has suggested a $500 billion program. Another has hinted it be $100 billion or less.

Still, even purchases of that size risk feeding inflation and, most dangerously, setting off a wave of speculative buying that could inflate the prices of stocks, bonds or other assets. Low mortgage rates after the 2001 recession were blamed for the housing bubble that burst and led to a severe recession starting in late 2007.

Yet another worry: The extra dollars flowing from the Fed's Treasury purchases might send the dollar's falling value even lower and incite a panic. If China and other investors dumped dollar-denominated assets, for instance, interest rates would soar.

And if tougher economic conditions forced the Treasury to sell more bonds to raise money, the national debt, already at $14 trillion, would swell.

The economy is growing at a pace "less vigorous than we would like," Bernanke acknowledged. And inflation is running too low for a healthy economy, he said.

Unemployment, now at 9.6 percent, has been stuck near double digits for more than a year. Bernanke indicated concern that economic growth will remain lackluster and that unemployment will decline only slowly next year. High unemployment would keep consumers cautious in their spending, Bernanke said.

Retail sales did rise in September for a third straight month, the government said Friday. But spending remains too weak to strengthen the economy and lower unemployment. That helps explain why the Fed wants to guard against falling prices.

Because the economy is still so sluggish, "the risk of deflation is higher than desirable," Bernanke said. Deflation is a widespread drop in prices, wages and the values of stocks and homes.

Deflation is dangerous for individuals, companies and the economy overall. Workers suffer pay cuts. Corporate profits decline. Stock values fall. People, businesses and the government find it costlier to pare debt. Foreclosures and bankruptcies rise.

And people spend less, convinced that prices will fall even further if they just wait. That trend is already evident in the housing market. Many would-be buyers are idling on the sidelines, expecting home prices to keep dropping.

As Bernanke spoke, the government issued a report that pointed to why a new Treasury-buying program may be necessary to ward off deflation. Consumer prices excluding the volatile categories of food and energy were flat for a second straight month in August.

This gauge, called "core" inflation, has ticked up just 0.8 percent over the past 12 months. That's the smallest annual gain in nearly a half-century. The Fed's inflation comfort zone is for such prices to hover between 1.5 percent and 2 percent.

[Associated Press; By JEANNINE AVERSA]

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