Fed Shift to Long-Term Assets May Show Limits to Its Power
September 22, 2011, 5:09 PM EDTBy Joshua Zumbrun and Scott Lanman
(Updates markets in fifth paragraph.)
Sept. 22 (Bloomberg) -- The Federal Reserve’s effort to reduce borrowing costs with an unconventional policy tool may also be highlighting limits to its power to fix what ails the U.S. economy.
Investors sought safer assets for a second day after the Fed announced it would shift $400 billion of its Treasury securities holdings into longer-term debt. Treasury 30-year bonds rallied, sending yields to the lowest level in almost three years, while the Dow Jones Industrial Average suffered its biggest two-day loss since December 2008.
Chairman Ben S. Bernanke and his policy-making colleagues yesterday cited “significant downside risks” to the outlook and responded with a program that economists say will provide at most a small boost to the recovery. The Fed should instead put more pressure on fiscal authorities to revive growth and outline a clear policy strategy, including setting a target for inflation, said Greg Hess, a former Fed researcher.
“The Fed needs to be answering questions, or providing confidence out there that answers questions, not just creating new ones,” said Hess, a professor and faculty dean at Claremont McKenna College in Claremont, California. “That’s why I think the response is negative and that’s why you’re seeing volatility rise.”
Yields on 30-year Treasuries declined to 2.8 percent at 4:22 p.m. in New York from 3.2 percent on Sept. 20. Stocks tumbled, with the Standard & Poor’s 500 index falling 3.2 percent in New York to 1,129.56, following a 2.9 percent drop yesterday. The Dow lost 3.5 percent to 10,733.83.
Strengthen Economy
That contrasts with the reaction to the second round of quantitative easing, when the S&P 500 rose 24 percent from the day Bernanke first signaled the policy in August 2010 to its conclusion in June. The rise in equities helped strengthen the economy, said Jerry Webman, chief economist at OppenheimerFunds Inc. in New York with $177 billion in assets under management.
“It would be helpful if someone would lay out exactly the economic mechanism that gets us from yet lower interest rates to actual economic activity,” Webman said. “Tell us why this is supposed to work because we’re missing something here. The market is obviously missing something here.”
The Chicago Board Options Exchange Volatility Index, a benchmark measure of stock volatility known as the VIX, jumped 13.2 percent to 42.26 at 3:53 p.m. in New York, bringing its four-day increase to 36 percent.
“The downside risks stem from situations such as Europe, the tax law and so forth,” said former St. Louis Fed President William Poole. “The Fed can’t offset those. It is not within the realm of monetary policy.”
Entire Speech
Bernanke should instead devote an entire speech to other issues that are holding back the recovery, such as tax policy and regulations, and make clear that the Fed is powerless to deal with them, Poole said.
“For the Fed to be doing these things that are extremely unlikely to have much current impact, it damages the Fed’s credibility,” Poole, a senior fellow with the Cato Institute in Washington, said in a telephone interview.
Economists in a Bloomberg News survey before the Fed’s meeting had low expectations for the action dubbed Operation Twist, with 61 percent saying the move would probably fail to reduce the 9.1 percent unemployment rate. Among those, 15 percent predicted it would be “somewhat harmful.” None of the 42 economists in the survey said the move would be “very effective.”
Home Loans
The central bank posted answers to “frequently asked questions” on its website, saying that the program should help lower costs for home loans, corporate bonds and other consumer and business lending. The plan “will provide additional stimulus to support the economic recovery but the effect is difficult to estimate precisely,” the Fed said.
The central bank purchased $2.3 trillion in debt from December 2008 through June in two rounds of so-called quantitative easing aimed at lowering borrowing costs for companies and consumers with the benchmark interest rate already at zero. The central bank lowered its target interest rate to zero, also in December 2008, and in August it pledged to hold the rate there through mid-2013.
With “Operation Twist” the Fed stopped short of some monetary policy options such as a third round of quantitative easing, a move seen as unlikely this year by 79 percent of economists in the Sept. 14-16 Bloomberg survey. Another option for the central bank comes from Chicago Fed President Charles Evans who supports tolerating a higher rate of inflation until unemployment falls below 7.5 percent.
Low Rates
Separately, the Fed released a study today showing that low mortgage rates in 2009 and 2010 did not lead to as much home refinancing as anticipated, underscoring the difficulty in spurring economic growth through interest rate reductions.
The housing market remains “depressed” in the FOMC’s words even after three years of low mortgage rates. New-home sales fell for the third straight month in July to an annual pace of 298,000, just above the record low pace of 278,000 sales in August 2010. The national average 30-year fixed-rate mortgage is at 4.09 percent, the lowest on record in a Freddie Mac index.
The central bank probably has small expectations for the policy, Alan Blinder, a former Fed vice chairman, said in an interview today on Bloomberg Television.
‘Throwing Sticks’
Through Operation Twist, Bernanke is “throwing sticks and stones and pea-shooters and BB guns and whatever he’s got at the weak economy in the effort to make marginal improvements,” said Blinder, a professor at Princeton University. “I don’t expect any miracles from it and frankly neither do they.”
Bernanke may have more success in spurring growth by signaling that interest rates will increase next year, which would get more people to borrow money now, said David Kelly, who helps oversee $408 billion as chief market strategist for JPMorgan Funds in New York.
“The public realizes that the Fed’s action is completely incapable of helping the economy out,” Kelly said of Operation Twist. “Ben Bernanke is at least trying to do the right thing. He just doesn’t know what the right thing is.”
--Editors: James Tyson, Vince Golle
To contact the reporters on this story: Joshua Zumbrun in Washington at jzumbrun@bloomberb.net; Scott Lanman in Washington at slanman@bloomberg.net.
To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net
