The Fed Plans to Spend a Trillion or More to Spur Growth

For the first time in a generation, the Federal Reserve has undertaken a campaign to influence long-term interest rates, a departure from recent monetary policy that has focused almost exclusively on short-term rates.

The Fed said it would buy up to $300 billion of longer-term government bonds, an additional $750 billion in mortgage-backed securities (bringing its total purchases of these securities up to $1.25 trillion this year), and twice the $100 billion debt it already said it would purchase from Freddie Mac and Fannie Mae.¹ The package is expected to help drive down interest rates on mortgages and other consumer loans. Because the Fed had already lowered its short-term interest-rate targets to almost zero, the government has essentially turned to printing money as a way to help expand the credit supply. Not since the 1960s has the central bank made such a direct attempt to influence long-term interest rates.²

Even though economists said the move had been expected for some time, some expressed surprise at the Fed’s timing. Economists expect the primary effect to be a swift and significant reduction in mortgage rates. This could help stimulate the housing market as well as allow homeowners to refinance at lower rates, which would increase household cash flows, leaving consumers with more money to spend. Because consumer spending represents the majority of economic activity, leaving consumers with more of their own money could increase economic activity and, by extension, raise employment levels.

However, not everyone is convinced. Were it not for the shrinking economy, a foray of this size into the debt markets would almost certainly ignite a serious bout of inflation — and it may eventually do so. But because inflation is a side effect of economic growth, the risk of a near-term increase in prices seems remote. The Fed appears to be more worried about deflation, or falling prices.

Other concerns include

A weakening of the dollar, which has a multitude of side effects, not all of which are bad. (Gold prices rose in the wake of the announcement, and the dollar fell against the euro and the yen.³ Gold is a favorite hedge against dollar weakness and inflation.)
A reluctance among banks to loan the cash raised from selling Treasuries, and the possibility that households and businesses that have been spooked by the barrage of bad economic news will hoard any gains and not spend additional money.
An overstated threat of deflation: flooding the economy with new money will in fact spark inflation.
The scope of the program — $300 billion would allow the Fed to buy about one-quarter of new government debt for six months — may be inadequate and require the government to print even more money in order to purchase greater amounts of government debt, further raising the risk of inflation while taking a psychological toll because of the unprecedented measures the government deems necessary to stimulate the economy.⁴
If the Fed’s action, in fact, causes inflation, the result will be an increase in interest rates and, paradoxically, higher Treasury yields.

What Does It Mean to You?

The Fed is essentially trying to make Treasury bonds less appealing for investors so that they will seek out other types of debt. Artificially increasing the demand for Treasury debt will induce higher prices and, if interest rates remain level, cause Treasury yields to fall. The move will likely raise the appeal of other types of debt and theoretically add liquidity to credit markets.

However, the risk that steep inflation will accompany the recovery is real, and everyone from consumers to investors to businesses could be affected if policymakers are unable to rein in a rapid increase in prices.

The markets were encouraged by the plan. The day of the announcement saw rallies in the stock and bond markets, and the yield on the benchmark 10-year Treasury note took the biggest one-day plunge since 1987.⁵ But it remains to be seen whether the upswing will last.

For homeowners, the effects may be mixed. Because the ability to refinance depends on whether the homeowner has equity, only those who are not underwater on their homes may benefit initially. Only if these measures are successful in stimulating the housing market will the benefits spread to more homeowners.

Exactly how — or whether— you should react to the Fed’s recent moves will depend on your personal circumstances. We can help you decide how to proceed.

1) Federal Reserve, 2009
2) Associated Press, March 18, 2009
3–5) The Wall Street Journal, March 18-19, 2009