Federal Reserve Taking the Short View

Buying up to $300 billion in long-term Treasuries and other moves should help prime the economy -- but not without risks.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

March 18, 2009

The Federal Reserve is not known for aiming its policy at the short run. Its role for many decades has been to take the long view. But this recession is threatening enough to spark an abrupt reversal in the Fed’s behavior. Its latest action is directed front and center at rescuing the economy as soon as possible, even if the actions create serious long-term challenges.

On March 18, the Federal Open Market Committee, the Fed’s policymaking arm, took the extraordinary measure of approving the Fed’s purchase of up to $300 billion in long-term Treasuries over the next six months. The Fed also will pump up the housing market through purchases of up to $750 billion in mortgage backed debt from Fannie Mae and Freddie Mac.

Such rare actions are being undertaken now that the Fed's benchmark short-term interest rate is near zero and the economy is still in horrible shape. In announcing its actions after policymakers met for two days on March 17-18, the FOMC noted that "the economy continues to contract.“

Buying long-term Treasuries is a controversial step. Critics say that down the road, when the economy is growing, the Fed will be forced to unload the bonds it buys now. The Fed could confront choices that would benefit neither taxpayers nor investors when it comes to selling the bonds because it would have to sell them at much lower prices and higher yields than originally issued.

That’s called inflation, and it’s very difficult to tame. Ask any Fed chairman. Still, the move has its backers, who say that in the short run it will keep interest rates low for mortgages and investment grade corporate bonds. "The potential benefits seem to outweigh their costs," especially because "the financial system remains impaired," says Richard Berner, chief North American economist with Morgan Stanley.

Even so, Fed Chairman Ben Bernanke is walking a tightrope. He wants to keep expectations from building that the economy is headed into a deflation spiral. To do that, he has acknowledged that the Fed is printing money. But that candor risks raising expectations that the Fed will let inflation run up quickly after the recession ends, devaluing the notes and bonds held by Treasury investors.

The Fed also opened the door to expanding its previously announced program of up to $1 trillion to rekindle borrowing among small businesses as well as consumers. The Fed is considering broadening the program to include other financial assets, which is raising speculation that the central bank will take over the role of working down the toxic debt on banks’ balance sheets that Treasury has been struggling to get a handle on for several months.

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