Federal Reserve Takes Action With Third Stimulus

4:58 PM, Sep 13, 2012   |    comments
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By Paul Davidson, USA TODAY

Moving to bolster the recovery, the Federal Reserve on Thursday agreed to buy $40 billion a month in mortgage-backed securities to cut borrowing costs for home buyers and other borrowers, and pledged to keep short-term rates near zero until at least mid-2015.

Markets reacted enthusiastically although an initial spike of nearly 1% in major indexes began to lose steam shortly after the Fed's announcement. In the afternoon, the rally regained power with major indexes showing gains of about 1.5% and trading close to levels not seen in nearly five years.

It's the first time since the Fed's bond purchases began in 2008 that it has made an open-ended plan to buy government securities.

Economists say it represents a more powerful commitment to pump money into the economy until job growth picks up significantly.

At a news conference Thursday, Fed Chairman Ben Bernanke said the new purchases are not "a panacea." "We don't have tools strong enough to solve the unemployment problem," he said.

But he added that the move can provide a "meaningful" and "significant" boost to a listless recovery. "We're just trying to get the economy moving in the right direction so we don't stagnate at high levels of unemployment," he said.

The open-ended mortgage bond purchases, he said, are designed to inspire "more confidence that the Fed will be there to do what it can."

"It's a bold move," says economist Michael Gapen of Barclays Capital. He predicts it will bring down mortgage rates by a quarter- to half-percentage point and add two tenths of a percentage point to economic growth over the next year. The strategy also should create 350,000 additional jobs and cut unemployment by another two-tenths of a percentage point over the next year, says Mark Zandi, chief economist of Moody's Analytics.

Fed policymakers also agreed to continue until year's end a program to buy long-term Treasury bonds and sell a similar amount in short-term bonds. Together, the programs will increase Fed holdings of long-term bonds by $85 billion a month through December, pushing down long-term interest rates.

The Fed slightly lowered its outlook for this year, projecting the economy will grow at an annual rate of 1.7% to 2%, down from the 1.9% to 2.4% pace it forecast in June. But it slightly raised its growth forecast for next year to an annual rate of 2.5% to 3%. It expects unemployment to be virtually unchanged by December, at 8% to 8.2%, and to fall only slowly to 7.5% to 8% by the end of 2013.

Lower long-term rates cut borrowing costs for consumers and businesses, theoretically stimulating the purchase of homes, cars and factory equipment.

By purchasing mortgage-backed securities rather than Treasury bonds, the Fed intends to more sharply bring down borrowing costs for home buyers in the critical housing market, which has improved recently but is still weak.

"They're trying to give a little bit of a boost to the resurgent housing market," says Steven Wyatt, finance chair at Miami University's Farmer School of Business.

The Fed in January pledged to keep interest rates near zero until at least late 2014 but extended the commitment Thursday because of the weak economy.

It's notable that the Fed agreed to continue the asset purchases and launch additional ones if job growth doesn't pick up significantly.

"If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases" and take other measures, the Fed said in a statement after a two-day meeting.

Bill Gross, founder and co-CIO of PIMCO investing group said: "Chairman Bernanke is articulating an intent to be 'all in' until the economy returns to a sustainable level of growth that lowers unemployment and generates appropriate job growth. That point seems at least several years away to me and therefore mortgage or other purchases will continue for the remainder of this year and beyond."

Gross added, " This is a reflationary policy that is seeking to return the economy to 5% nominal growth whether that growth rate is currently specified by the Fed. The Fed's balance sheet will expand from ... to $5 trillion before this ends." Many economists have been predicting for weeks that the Fed would move Thursday to re-energize a three-year-old recovery that has shown recent signs of flagging. Stock markets have risen sharply in anticipation of the move.

Job growth, though steady since early 2010, is still weak. The economy gained 96,000 jobs last month, far less than in July. The unemployment rate, at 8.1%, is a percentage point lower than a year ago but has stayed stubbornly above 8% for 3 1/2 years. Other recent data have shown exports falling, manufacturing weakening, and consumer confidence declining.

With a divided Congress taking no significant steps to stimulate growth, the Fed's easy-money policies are seen by many as the sole antidote for an ailing economy, even if its benefits are limited.

Falling bond yields steer investors from bonds to stocks, increasing household wealth and spurring more consumer spending. The lower interest rates also make U.S. bond investments less attractive, pushing down the dollar. That aids exports by making U.S. products cheaper.

The Fed has spent $2.3 trillion since late 2008 buying Treasury and government-backed mortgage bonds in an effort to push down longer-term interest rates that consumers and businesses pay to borrow, and to steer investors from bonds into stocks.

The central bank took the unprecedented action because it had done all it could through conventional methods, including holding a key short-term interest rate near zero since 2008. Stock prices have gotten a lift in anticipation of each new round of the Fed's stimulus actions, known as a "quantitative easing."

The Fed's two previous rounds of quantitative easings haven't been enough to put the recovery on a solid growth path. The Fed's efforts have faced strong headwinds, such as the European debt crisis and battles in Congress over the federal debt.

Each successive easing has had less impact than the one before it, and Fed Chair Ben Bernanke has acknowledged that the benefits of stimulus have diminished and risks, such as eventual inflation, have increased.

The Fed's statement Thursday was the most recent in a series of increasingly worried statements over the past few months, says Greg Whiteley, government securities portfolio manager at DoubleLine Capital. The Fed had said earlier that it would take action if there was further deterioration in the economy, Whitely says. The most recent statement said that the Fed would continue to take action until there is substantial improvement in outlook for the labor market.

The Fed's purchasing of mortgage-backed securities means that mortgage rates should continue to stay low, says Dan Fuss, manager of Loomis Sayles Bond. The current average 30-year mortgage rate is 3.55%, according to mortgage giant Freddie Mac. Homeowners who can refinance their mortgage can lower their payments, putting extra money in their pockets. "It may even get lenders to loosen up a touch on their terms," says Fuss.

Low rates means stocks will look more attractive to investors than bonds. The 10-year Treasury note currently yields 1.78%; the Dow Jones industrial average has rallied more than 150 points so far Thursday on the Fed news.

Bonds yields, however, have risen on the news, in part out of fear that the Fed's easing will increase the likelihood of inflation, which erodes the value of a bond's fixed interest rate. "The reaction has been negative," Whiteley says. The yield on the 30-year Treasury bond, for example, is nearly 3% now, up from 2.47% in July. Bond prices fall when yields rise.

Fed officials say political considerations do not enter into their decisions, but intervening in the economy now -- in the final weeks of a heated presidential campaign -- would go against longstanding convention and could make the Fed a target for criticism.

In an Aug. 23 interview with Fox News, GOP candidate Mitt Romney criticized the Fed's second QE round as ineffective and said a QE3 is "the wrong way to go." In keeping with longstanding tradition, President Obama has not specifically commented on the Federal Reserve.

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