U.S. Federal Reserve to spend $45B a month to buy bonds

The Associated Press ~ staff OBJ
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The U.S. Federal Reserve sent its clearest signal to date Wednesday that it will keep interest rates super-low to boost the U.S. economy even after the job market has improved significantly.

(Stock image)

The Fed says it plans to keep its key short-term rate near zero at least until the unemployment rate drops below 6.5 per cent - as long as expected inflation remains no more than 2.5 per cent. Unemployment is now 7.7 per cent. Annual inflation is about two per cent.

That plan adds detail to what the Fed had said before: that it expects to keep the rate low until at least mid-2015.

In a statement Wednesday after its final policy meeting of the year, the Fed also said it will keep spending $85 billion (all figures U.S.) a month on bond purchases to drive down long-term borrowing costs and stimulate economic growth.

The Fed will spend $45 billion a month on long-term Treasury purchases to replace a previous bond-purchase program of an equal size. And it will keep buying $40 billion a month in mortgage bonds.

"The Fed has become more explicit and more transparent," said Steven Wood, chief economist at Insight Economics. "This should provide the markets with much more clarity around monetary policy action in the upcoming year."

With its new purchases of long-term Treasurys, the Fed's investment portfolio, which is nearly $3 trillion, would swell to nearly $4 trillion by the end of 2013 if its bond purchase programs remain in place.

The policies are intended to help an economy that the Fed says is growing only modestly.

Stocks and bond yields rose after the Fed's statement was released. The Dow Jones industrial average was little changed just before the Fed news crossed at 12:30 p.m. Eastern time and jumped 69 points shortly after.

The yield on the benchmark 10-year Treasury note rose to 1.69 per cent from 1.65 per cent as investors sold ultra-safe investments and moved money into stocks.

The Fed's plan to keep stimulating the economy at least until unemployment has reached 6.5 per cent is intended to reassure consumers, companies and investors, said Joseph Gagnon, a former Fed official who is a senior fellow at the Peterson Institute for International Economics.

Having only a target date of mid-2015 for any increase in interest rates "sounded gloomy," as if the economy would remain weak until then, Gagnon said. Specifying an unemployment rate - close to a normal rate of six per cent or less - makes clear that the Fed will keep stimulating the economy even after the job market has strengthened.

"This is trying to get away from that sense of 'Oh, my God, this is all about gloom and doom,'" Gagnon said.

The Fed's new plan to link any rate increase to specific levels of unemployment and inflation mirrors a proposal pushed by Charles Evans, president of the Federal Reserve Bank of Chicago.

The Fed said it can pursue the aggressive stimulus programs because inflation remains below its target. Its statement was approved on an 11-1 vote. Jeffrey Lacker, president of Federal Reserve Bank of Richmond, objected for the eighth time this year.

The meeting was held against the backdrop of the looming "fiscal cliff," the sharp tax increases and spending cuts that will hit the economy in January if Congress and President Barack Obama are unable to reach an agreement this month to avert them.

Bernanke has said that the Fed's efforts will not be able to rescue the economy if the budget negotiations fail and the country does go over the fiscal cliff.

Fears of the cliff have led some U.S. companies to delay expanding, investing and hiring. Manufacturing has slumped. Consumers have cut back on spending. Unemployment remains elevated. If higher taxes and government spending cuts were to last for much of 2013, most experts say the economy would sink into another recession.

The latest bond-buying program would replace an expiring program called Operation Twist. With Twist, the Fed sold $45 billion a month in short-term Treasurys and used the proceeds to buy the same amount in longer-term Treasurys.

Twist didn't expand the Fed's investment portfolio, it just reshuffled the holdings. But the Fed has run out of short-term securities to sell. So to maintain its pace of long-term Treasury purchases and to keep long-term rates low, it must spend more and increase its portfolio.

The Fed's portfolio totals nearly $2.9 trillion - more than three times its size before the 2008 financial crisis.

The Fed has launched three rounds of bond purchases since the financial crisis hit. In announcing a third program in September, the Fed said it would keep buying mortgage bonds until the job market improved substantially.

Skeptics note that rates on mortgages and many other loans are already at or near all-time lows. So any further declines in rates engineered by the Fed might offer little economic benefit.

Inside and outside the Fed, a debate has raged over whether the Fed's actions have helped support the economy over the past four years, whether they will ignite inflation later and whether they should be extended.

Organizations: U.S. Federal Reserve, Insight Economics, Dow Jones industrial average Peterson Institute for International Economics Federal Reserve Bank of Chicago Federal Reserve Bank of Richmond

Geographic location: U.S.

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