Fed redo on bonds expected by today

Federal Reserve Chairman Ben Bernanke (right) attends an event in Richmond, Va., with Jeffrey Lacker, president of the Federal Reserve of Richmond in 2010.
Federal Reserve Chairman Ben Bernanke (right) attends an event in Richmond, Va., with Jeffrey Lacker, president of the Federal Reserve of Richmond in 2010.

— The Federal Reserve is expected to announce a revamped bond-buying plan today to maintain its ongoing efforts to support the U.S. economy.

The Fed’s goal is to keep downward pressure on long-term interest rates and encourage individuals and companies to borrow and spend. If it succeeds, the Fed might at least soften the blow from the “fiscal cliff” of tax increases and spending cuts that will kick in beginning in January if Congress can’t reach a budget deal.

But Fed Chairman Ben Bernanke warned last month that if the economy fell off a “broad fiscal cliff,” the Fed probably couldn’t offset the shock.

Fears of the drastic federal budget cuts and tax increases threatened by the so-called fiscal cliff have led some U.S. companies to delay expanding, investing and hiring.

As negotiations continue between President Barack Obama’s administration and House Republican leadership, manufacturing has slumped and consumers appear to have cut back on spending. Unemployment remains a still-high 7.7 percent. If higher taxes and government spending cuts go into effect and last for much of 2013, many experts worry the economy will sink into another recession.

On Tuesday, the Fed began a two-day meeting, which will end today with a statement announcing its policy decisions. Afterward, the Fed will update its forecasts for the economy, and Bernanke is expected to hold a news conference.

The Fed is expected to unveil a program to buy $45 billion a month in long-term Treasury securities — replacing an expiring program called “Operation Twist.” With Twist, the Fed sold $45 billion a month in short-term Treasuries and used the proceeds to buy the same amount in longer-term Treasuries.

Twist didn’t expand the Fed’s investment portfolio; it just reshuffled the holdings. But the Fed has run out of short-term securities to sell. So to maintain its pace of long-term Treasury purchases and help keep long-term rates low, it must spend more and increase its portfolio.

The new bond purchase plan would be in addition to a program announced in September where the Fed buys $40 billion a month in mortgage bonds to try to force already record-low home-loan rates lower to encourage home buying.

“The Fed really has only one key decision at the meeting, and that is how much of the current program will they replace,” said David Jones, chief economist at DMJ Advisors.

If, on the other hand, the Fed chooses not to replace Twist with a new bond-buying program, the value of its long-term Treasury purchases will decline by half — which could cause long-term borrowing rates to rise.

When the Fed pumps more money into the financial system and adds to its portfolio, it’s called quantitative easing. Critics argue that quantitative easing risks escalating inflation. The Fed’s portfolio totals nearly $2.9 trillion — more than three times its size before the 2008 financial crisis.

The Fed has launched three rounds of quantitative easing since the financial crisis hit. In announcing the third round in September, the Fed said it would keep buying mortgage bonds until the job market improved substantially. It also extended its plan to keep its benchmark short-term rate near zero through at least mid-2015. And it raised the possibility of taking other steps.

Skeptics note that rates on mortgages and many other loans are already at or near all-time lows. So any further declines in rates engineered by the Fed might offer little economic benefit.

But besides seeking to spur lending, the Fed’s drive to cut rates has another goal: to induce investors to shift money out of low-yielding bonds and into stocks, which could lift stock prices. Stock gains boost wealth and typically lead people and businesses to spend and invest more. If that happened, the economy would benefit.

Inside and outside the Fed, there has been a debate over whether the Fed’s actions have helped support the economy over the past four years, whether they will ignite inflation later and whether they should be extended. At this week’s meeting, some regional Fed bank presidents will likely express concern that more bond buying will further flood the financial system with money and eventually send prices soaring.

One such critic, Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, has cast the lone dissenting vote at all seven Fed policy meetings this year. Lacker has said he thinks the job market is being slowed by factors beyond the Fed’s control. And he says further bond purchases risk worsening future inflation.

Others, like John Williams, president of the San Francisco Fed, have said they think the Fed’s bond purchases must continue because the job market and other components of the economy are improving only gradually.

The Fed is also expected this week to resume discussions on how to signal future policy moves to the public more clearly. Since August 2011, the Fed has identified a target date to try to reassure markets that it doesn’t plan to raise short-term rates soon.

Some Fed officials, however, oppose using a target period to signal the earliest when it might start raising rates. They’ve been urging that future interest-rate moves be linked to how the economy is faring as measured by unemployment and inflation.

Chicago Fed President Charles Evans, a proponent of this change, would set the unemployment target at 6.5 percent and the inflation target at 2.5 percent. If those targets were adopted, the Fed would say it didn’t plan to raise rates until unemployment drops below 6.5 percent — as long as the Fed’s inflation gauge is no more than 2.5 percent. The Fed’s inflation measure over the past 12 months has risen just 1.7 percent, signaling that inflation pressures are wellcontained.

Many private economists expect no change in the Fed’s communications strategy this week. They think officials are far from a consensus on how to adopt numerical targets for any interest-rate move. But a change could come next year.

By contrast, there’s expectation that the Fed will announce a program to replace Operation Twist. If it didn’t, the Fed’s support for the economy would be reduced at a time when growth is weak and unemployment still high.

“They can’t have the current level of bond buying come to an end with all the uncertainty of the fiscal cliff just around the corner,” said Greg McBride, senior financial analyst at Bankrate.com.

Business, Pages 25 on 12/12/2012

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