The Wall Street Journal
By: Jon Hilsenrath
November 4, 2010
The Federal Reserve, in a dramatic effort to rev up a "disappointingly slow" economic recovery, said it will buy $600 billion of U.S. government bonds over the next eight months to drive down interest rates and encourage more borrowing and growth.
Many outside the Fed, and some inside, see the move as a 'Hail Mary' pass by Fed Chairman Ben Bernanke. He embraced highly unconventional policies during the financial crisis to ward off a financial-system collapse. But a year and a half later, he confronts an economy hobbled by high unemployment, a gridlocked political system and the threat of a Japan-like period of deflation, or a debilitating fall in consumer prices.
The Fed left open the possibility of doing more if growth and inflation don't perk up in the months ahead. The $75 billion a month in new purchases of Treasury debt come on top of $35 billion a month the Fed is expected to spend to replace mortgage bonds in its portfolio that are being retired.
The Dow Jones Industrial Average Wednesday continued a climb that began in August, when Mr. Bernanke signaled that a bond-buying program was possible. The index rose 26.41 points, or 0.24%, to a two-year high of 11215.13. Yields on 10-year notes, which have fallen from just under 3% in early August, finished the day at 2.62%. The value of the dollar has fallen in anticipation of a flood of new American currency hitting global financial markets.
These market reactions are seen inside the Fed as being stimulative to the economy. In addition to the impact of cheaper borrowing, higher stock prices could encourage households to spend more and businesses to invest more, and a weak dollar could make U.S. exports cheaper and thus easier to sell abroad.
"All of these things are part of what the Fed is trying to do, and I think it has been successful," said Laurence Kantor, head of research at Barclays Capital in New York.
The moves announced Wednesday were broadly in line with the expectations of economists, although some had expected total spending to be a bit less and to come more quickly.
There are immense unknowns and many risks.
In essence, the Fed now will print money to buy as much as $900 billion in U.S. government bonds through June--an amount roughly equal to the government's total projected borrowing needs over that period.
In normal times, a Fed spending spree on government bonds would be highly inflationary, because it would flood the economy with money and raise worries about too much government spending. The mere worry of too much inflation in financial markets could drive long-term interest rates higher and cause the Fed's program to backfire.
Michael Pence, a top Republican in the House of Representatives, said the Fed was taking an "incalculable risk."
Thomas Hoenig, the president of the Federal Reserve Bank of Kansas City, who described the move before the meeting as a "bargain with the devil," was the lone dissenter in a 10-1 vote of the Fed's policy committee. He said the risks of additional government bond purchases outweighed the benefits.
But Fed officials are betting that inflation is still being pushed strongly in the other direction because there is so much spare capacity in the economy--including an unemployment rate at 9.6%, a real-estate landscape littered with more than 14 million unoccupied homes, and manufacturers operating with 28% of their productive capacity going unused.
The latest economic data suggest the economy is expanding, but not at a very fast pace. Figures Wednesday from payroll firm Automatic Data Processing Inc. and consultancy Macroeconomic Advisers showed that companies added 43,000 private-sector jobs in October.
In a post-meeting statement, the Fed said it was acting to "promote a stronger pace of economic recovery" and to ensure that inflation, now running at around a 1% annual rate, moves toward the Fed's informal objective of 2%.
This is the Fed's second experiment with a big bond-buying program. Between January 2009 and March of this year, the central bank purchased roughly $1.7 trillion worth of government and mortgage bonds. That move also sparked worries about inflation, which so far hasn't materialized. The bond-buying program is known in some corners as quantitative easing.
"This approach eased financial conditions in the past and, so far, looks to be effective again," Mr. Bernanke said in an opinion piece scheduled to be published in Thursday's Washington Post.
By buying a lot of bonds and taking them off the market, the Fed expects to push up their prices and push down their yields. The Fed hopes that will result in lower interest rates for homeowners, consumers and businesses, which in turn will encourage more of them to borrow, spend and invest. The Fed figures it will also drive investors into stocks, corporate bonds and other riskier investments offering higher returns.
The Fed normally would push down short-term interest rates when the economy is weak. But it has already pushed those rates to near zero, leaving it to resort to unconventional measures.
The planned bond buying, by Fed calculations, will have an economic impact roughly equivalent to cutting short-term interest rates by three-quarters of a percentage point.
The Fed will be buying bonds with maturities of as long as 30 years, but will concentrate its purchases in the five-year to six-year range. Some bond-market participants were disappointed with that decision because they wanted the Fed to focus on buying longer-term bonds. But doing so could leave the Fed more exposed to losses if interest rates rise.
There are other risks.
Critics say a weaker dollar isn't in U.S. interests, and that a swift decline in the value of the currency could drive up U.S. interest rates. Fed officials have seen the dollar's drop to date as being orderly and supportive of growth.
Some critics also argue that by purchasing government bonds, the Fed is taking pressure off the White House and Congress to address long-term deficit problems, but Mr. Bernanke is trying to avoid such political calculations.
U.S. trading partners, particularly in the developing world, openly worry that the Fed's money pumping is creating inflation in their own economies and a risk of asset-price bubbles. Fed officials say a strong U.S. economy is in everyone's interest.
In recent weeks, China, India, Australia and others have pushed their own interest rates higher to tamp down inflation forces. Authorities in Brazil and Thailand have imposed taxes on capital flooding into their economies to prevent an asset bubble. And Japanese authorities have intervened in currency markets to prevent the yen from appreciating too much against the dollar.
There is an alternate risk that officials wrestled with in their latest two-day meeting, which concluded before lunch Wednesday: They might not be doing enough.
Economists at the research firm Macroeconomic Advisers LLC calculated that even if the Fed purchases $1.5 trillion worth of Treasury bonds--which some economists say remains a distinct possibility--it would only bring the unemployment rate down by 0.2 percentage points by the end of 2011.
"This instrument doesn't give them a lot of power, especially on the scale which they're prepared to use," said Laurence Meyer, of Macroeconomic Advisers, after the decision.
For the Fed, it was a middle ground that emerged after months of internal debate about the costs and benefits of restarting the program.
Write to Jon Hilsenrath at firstname.lastname@example.org