The Federal Reserve opened a new era in US monetary history, cutting interest rates to as low as zero and pledging to buy unlimited quantities of securities, after conventional policies failed to arrest what may be the worst recession since World War II.
The new strategy is likely to involve unusually close cooperation with the Treasury of President-elect Barack Obama, which is still formulating its economic-rescue plans. The aim is to kick-start borrowing and spending to propel the economy toward a recovery by the middle of next year.
“It’s going to take a combination of fiscal and monetary stimulus to get the job done,” said former Fed Governor Lyle Gramley, now senior economic adviser at Stanford Group Co in Washington. The central bank has signalled it will “make sure that the fiscal stimulus package, which is going to be a big one, is fully supported” and “in effect financed by the Fed.”
Possible steps by the Fed in coming months include financing for a new package to shore up the housing industry, and expanding a $200 billion programme to undergird credit card and student loans. The new plan is risky: market pricing could be distorted for months or years, with insolvent borrowers kept afloat as central bankers force yields below levels investors deem appropriate given the risks.
The Fed’s Open-Market Committee on Tuesday said it will use “all available tools” to generate a resumption in growth. The FOMC also effectively retired its benchmark interest rate, bringing the target for overnight loans between banks down to zero to 0.25 per cent from 1 per cent previously.
Stocks surged as the clarity of the Fed’s commitment exceeded some investors’ forecasts. Treasuries jumped in anticipation of Fed purchases, and mortgage bonds rallied. The Standard & Poor’s 500 Stock Index rose 5.1 per cent to a five- week high. Benchmark 10-year note yields fell more than a quarter point, to 2.26 per cent.
Among new ideas the Fed is open to is buying lower-rated securities, with backing from the Treasury, a senior Fed official told reporters yesterday in Washington. Central bankers plan to discuss possible strategies with Obama’s Treasury, the person said.
Obama’s pick for Treasury secretary is Timothy Geithner, the president of the New York Fed, who has been Bernanke’s closest adviser on the emergency lending programs that the central bank has already introduced during the 16-month financial crisis.
Obama met with Geithner, former Treasury Secretary Lawrence Summers and other members of his economic team on Tuesday in Chicago as he assembles plans for a two-year fiscal stimulus package after he takes office January 20. Among his other priorities is a new, comprehensive effort to use taxpayer funds to stem record mortgage foreclosures.
“We are running out of the traditional ammunition that is used in a recession,” Obama said at a news conference on Tuesday. While the Fed is going to have “more tools available to it, it is critical that the other branches of government step up,” he said.
The Fed said on Tuesday that it may expand its $600 billion initiative to buy debt issued or backed by government-chartered mortgage-finance companies. It is also “evaluating” purchases of longer-term Treasury securities.
“The only meaningful limitation right now is their capacity to be creative,” said David Resler, chief economist at Nomura Securities International Inc., New York. “The Fed is telling us there is just about nothing off the table.”
Other existing programmes include an unlimited effort to buy commercial paper from companies and financial firms and a backstop for money-market mutual funds.
The central bank can make a difference in credit markets where yields are higher than they would otherwise be because of a lack of liquidity due to the financial crisis, the senior Fed official said. Still, inserting the Fed as a main purchaser in those markets raises the danger of delaying a recovery in private lending, some observers said.
“The availability of Fed credit might deter private credit,” said Vincent Reinhart, resident scholar at the American Enterprise Institute in Washington and former director of the Division of Monetary Affairs at the Fed Board. “The lender of last resort becomes the lender of only resort.”
The composition and size of the balance sheet will be the Fed’s new policy focus, the senior central bank official said in a conference call. Unlike Japan’s quantitative easing policies earlier this decade, the Fed is targeting specific assets for purchase to lower credit spreads rather than expanding the amount of cash in the banking system, the senior official said.
“Quantitative easing American style is what they’re giving us,” said Allen Sinai, chief global economist at Decision Economics Inc, New York. “The Japanese style was to buy government maturities. The US style is directly buying agency securities, buying mortgage-backed securities and lending money right into the private sector.”
The central bank is also considering whether to provide more information about the composition and targeted size of its balance sheet, the senior Fed official said on condition of anonymity.
“The focus of the committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level,” the FOMC said.
The deepening economic slump pushed unemployment to 6.7 percent last month, the highest level since 1993, while builders broke ground on the fewest new homes since record-keeping began in 1947.
Consumer prices fell the most on record in November, the Labor Department said Tuesday. Fed officials don’t see an immediate risk of a collapse in prices, or deflation, the senior official said.
