Federal Reserve To Buy U.S. Debt, Shifts Policies As Recovery Falters

Federal Reserve officials agreed Tuesday afternoon to a new step aimed at supporting the economy by reinvesting money from Fed-owned securities as they mature. The action signaled deeper concerns about the slow pace of the economic recovery.

The Fed will use the proceeds from its investments in mortgage bonds to buy government debt instruments. That should help lower interest rates on mortgages and corporate debt, but it won’t likely have a dramatic impact on stimulating growth, economists say, because the effort is too small and is only part of the equation to re-stimulate the economy.

With a new, pessimistic assessment of the recovery, the Fed now admits that economic growth will be “more modest” than anticipated at its June meeting.

The focus, again, on energizing the recovery is a shift from earlier this year when the Fed was discussing its exit strategy for eventually boosting interest rates.

Fed leaders are starting to address the growing risk that the recovery could stall altogether and that prices could even begin falling. In a deflationary spiral — like that experienced by Japan in the 1990s — falling prices lead people to hoard cash, which weakens the economy further, and debts become even more burdensome.

The Fed is essentially saying that if the economy were to deteriorate and a return to recession appeared imminent, the central bank would react by resuming its purchases of long-term Treasury bonds — not just buying enough to replace the mortgage securities it holds as they mature, but actually increasing its total holdings.

The Fed is able to pump money into the economy by buying bonds — in effect, it creates money out of thin air and uses it to pay investors for the bonds. This helps push interest rates down, which should make it cheaper for Americans to consume and invest. However, if Americans lack confidence in the future, low interest rates may not be enough.

Hence the need for even further federal stimulus programs… Congress has more power than the Fed to stimulate the recovery, many economists say, because if “the people” and business continue to curtail spending and hiring, then the federal government is the “spender of last resort.” But they differ on whether the best action is through short-term government spending or tax cuts, or some combination of the two.

Fed leaders did not take any other steps to support growth, such as adding to the securities on its balance sheet (adding student loans, government and corporate bonds, more mortgage instruments) — as has been suggested, on a massive scale, here within several recent posts.

Several economists agree that the move to buy government debt on a relatively small scale — about $10 billion a month — along with the other options at the Fed’s disposal, will have only a marginal impact on boosting economic growth without a much larger effort. Still… the Fed’s move signals a significant change in attitude and approach. More action is certain to come.

“They (the Federal Reserve Board) seem to have quite a handle on what’s going on, which is what you want them to do,” said Robert Pavlik, chief market strategist at Banyan Partners LLC in New York.

The Fed said it would use the proceeds it’s earning on mortgage bonds to buy two-year and 10-year Treasuries, and that it would buy an equal amount of government debt as existing bonds mature. The net effect is to keep its $2.3 trillion balance sheet steady, while shifting its holdings into more government debt. The effort should be larger, but this is a start.

In 2009 and early 2010, the Fed bought $1.25 trillion in mortgage securities, $175 billion in mortgage debt from Fannie Mae and Freddie Mac, and $300 billion in government debt.

In March, the Fed ceased buying new mortgage securities and Fannie and Freddie debt, and this is when we began to discuss here that the economy would falter and deflation would threaten to rear its ugly head, requiring a larger effort by the Fed to absorb debt securities and bonds along with another round of stimulus funding.

Economists are skeptical that cheaper credit or even more government aid will get Americans shopping more and businesses to hire. They also say some jobs in construction and other housing-related fields, and in manufacturing, will never return to pre-recession levels, as the economy makes a structural shift.

Problems:

  • High unemployment, lackluster income growth, sagging home values and tight credit are all restraining the pace of consumer spending
  • Businesses, meanwhile, are reluctant to hire and commercial real estate is weak, other drags on the recovery

Solutions:

  • More Fed purchases of debt securities
  • More stimulus spending on massive technology and capital programs to:
    • rebuild our crumbling infrastructure
    • create high speed rail
    • implement the smart electric grid
    • and invest in alternative fuel infrastructure.

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