News Analysis

The Fed Breaks Out the Heavy Artillery


With the furor over American International Group (AIG) bonuses distracting Congress and the Obama Administration, the Federal Reserve thrust itself back to the front lines on Mar. 18 with a trillion-dollar-plus campaign of shock and awe against the deepening recession. At the conclusion of its two-day policy meeting, the independent central bank—which doesn't have to ask anyone for permission to spend money—committed itself to buying enormous quantities of asset-backed securities and debt in order to lower interest rates and revive housing, consumer lending, and small-business loans.

"With the rest of Washington moving in slow motion (and in some cases hindering the revival in capital markets), the Fed continues to move ahead aggressively," Barclays Capital (BCS) economist Ethan Harris wrote after the announcement.

Math reminder: A billion is a thousand million, and a trillion is a thousand billion. So the size of the Fed's intervention makes the $165 million worth of bonuses to executives of AIG look puny in quantitative terms—while not, of course, diminishing their moral and political significance.

Statement Full of Surprises

Expectations of Fed buying raised the prices, and consequently pushed down the interest rate yields, on mortgage-backed securities as well as Treasury bonds, which were included in the deal. Stocks rose slightly as well, while the dollar fell on inflation worries. The yield on the benchmark 10-year Treasury note plummeted one-half percentage point, to around 2.5%.

"The good news is that the Fed is clearly being a lot more aggressive," said Desmond Lachman, a resident fellow at the American Enterprise Institute. "The bad news is that I think it reflects their assessment that the economy is a whole lot weaker than they thought it would be."

The Fed did not cut short-term interest rates because it can't—they're already at virtually zero. The post-meeting statement said the rate-setting Federal Open Market Committee "anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

The FOMC statement was full of surprises, albeit in the Fed's typical bland language. The Fed committed itself to buying another $750 billion this year in mortgage-backed securities issued by "agencies" like Fannie Mae and Freddie Mac, on top of the $500 billion it had already committed to buying. It doubled to $200 billion the amount of agency debt it will buy this year.

And in a surprising change of direction, the Fed said it will buy $300 billion of longer-term Treasury securities. Up until now, Federal Reserve Chairman Ben Bernanke had said there was no need for the Fed to buy Treasuries since there was a strong market for them already. The Fed's new thinking seems to be that it can't hurt to try a little Treasury buying in hopes that the money will trickle down to non-Treasury securities. It said the goal of the Treasury purchases is "to help improve conditions in private credit markets."

Aimed at Boosting Market Psychology

Lachman hypothesized that one reason for the Fed's aggressiveness is that Congress—frozen in place by the public's revulsion over the AIG bonuses—is unlikely to advance any more money for bailouts of financial institutions, even though many still need help to become healthy. "This political circus that's going on over AIG means there's not going to be any more money for banks," Lachman said in a conference call with journalists after the Fed statement.

The Fed's statement probably was intended to have a psychological impact on the markets, because the Fed went further than it needed to in announcing the new purchases. Harm Bandholz, economist at UniCredit Research in New York, noted that the Fed had bought only 19% of the mortgage-backed securities and only 40% of the agency debt that it had already said it was buying, so there was no rush to announce more purchases.

Economists differed on the likely effectiveness of the Fed's efforts. Joseph Mason, a professor at Louisiana State University's E.J. Ourso College of Business, worried that unless banks are repaired, the Fed's efforts to push money into the economy will be no more effective than "pushing on a string."

But Paul Dales, an economist for Capital Economics, wrote in a report after the Fed statement that "the sheer size of the measures suggests that they will do some good, thus increasing the chances of a decent recovery next year. At the least, no one can say that the Fed isn't trying."

Coy is BusinessWeek's Economics editor.

Coy_190
Coy is Bloomberg Businessweek's economics editor. His Twitter handle is @petercoy.

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