Fed’s treasury-bond gambit: mother of all rescue plans

As much as $1 trillion will lower long-term loan rates like mortgages but it raises the specter of inflation.

The Federal Reserve’s unexpected move this week to pump as much as $1 trillion of new money into the economy is being hailed by some analysts as the move “most likely to succeed” in lifting America out of recession. It promises to affect Americans in numerous ways – lowering interest rates on mortgage loans and small-business borrowing.

The Fed’s plan is to purchase massive quantities of Treasury bonds and mortgage-related securities in a bid to bring the cost of credit down for ordinary borrowers, and to keep it down for an extended period.

Early reactions were positive: Stock prices rose, Treasury borrowing costs plunged, and mortgage rates fell. But the action is not without risks both to inflation and financing future US debt.

The value of the dollar sank on foreign-exchange markets and commodity prices rose in response – signs that the Fed could lose control of inflation down the road, and make foreign investors less willing to buy America’s debt. But many forecasters say the Fed’s move boosts the prospects for an economic recovery later this year.

“Of all the things that Washington has put together to get us out of this financial mess, I think what happened Wednesday is probably the most important,” says Ed Yardeni, an economist who heads Yardeni Research in Great Neck, N.Y. “This affects so many people.”

But markets have shown that the Fed’s attempts to energize the economy don’t always work as intended. The Fed has already slashed its own short-term interest rate virtually to zero during the past year and has introduced a range of large, innovative programs to get credit flowing again. Yet turmoil in credit markets has persisted, and job losses have mounted.

One forward-looking gauge of economic activity, the index of leading indicators, fell by 0.4 in February, the Conference Board reported Thursday.

Still, the new moves, supported by a unanimous vote of the Fed’s policymaking committee, suggest a renewed commitment to open floodgates of liquidity as needed to end an unusually deep and long recession. In sheer dollars to be deployed, some economists also say it’s the largest-scale effort to date – by the Fed or the White House and Congress.

“This trumps any of the other plans,” Yardeni says.

The Fed said it will:

•Purchase as much as $300 billion of longer-term Treasury securities during the next six months.

•Buy an additional $750 billion of mortgage securities, bringing its purchases of these securities to up to $1.25 trillion this year.

•Double its purchases this year of debt issued by mortgage giants Fannie Mae and Freddie Mac, up to a total of $200 billion

•Expand the types of lending it will support through an already announced program, spurring business and consumer loans by providing credit to investors who buy a range of loan-backed securities.

By becoming a huge buyer of Treasury and mortgage-agency bonds, the Fed is basically pushing the price of those bonds up. The flip-side effect is to push down the yield, or interest rate. The effect should be to lower the borrowing costs. This should be a boon for the US government, which is issuing lots of new debt as it spends to buoy the economy.

It will help home buyers and people who want to refinance mortgage loans.

“Mortgage rates now are decisively below 5 percent, and should settle somewhere between 4 and 4.5 percent,” Yardeni says, referring to cost of a benchmark 30-year fixed-rate mortgage.

The lower interest rates on Treasury bonds also help shape many other interest rates for consumers and business, so a positive ripple effect should be felt broadly through the economy.

The moves could work hand-in-hand with other policies designed to fight the recession, such as the Obama administration’s recently announced program to widen the number of at-risk homeowners who can refinance to avoid foreclosure – and an $8,000 tax credit for first-time home buyers.

Moreover, with all its bond-buying activity, the Fed is expanding the money supply at a time when many economists say that is needed. The recession, by crimping the flow of credit and economic activity, means that the so-called velocity of money – the pace at which it circulates through the economy – has slowed down.

In that environment, economists say the Fed can pump new money into the economy without fueling inflation.

Yet the central bank knows it must be careful. Massive Fed interventions raise the risk that investors will start seeing inflation on the horizon and act accordingly.

If that sentiment takes hold, it could make it hard for the Fed to achieve its objectives. Even as the Fed is buying Treasuries, private-sector investors might start selling them – both on expectations of an improving economy and of rising inflation. That could push interest rates up.

Oil prices jumped above $50 a barrel Thursday, and gold prices surged, amid a broad rally in commodities that are seen as a hedge against inflation. At a time when the US relies on foreign investors to buy many of its debts, the dollar also fell.

Desmond Lachman, an economist at the American Enterprise Institute in Washington, says that weakness in European economies should prevent a sharp slide for the dollar.

The Fed is “doing the right thing in present circumstances,” he says.