Federal Reserve Will Keep Buying Bonds

It’s full steam ahead for the Federal Reserve’s plan to buy $600 billion worth of Treasury debt by next June as it seeks to accelerate growth of the economy and lower the unemployment rate from 9.8 percent.

Fed watchers were looking for any sign from the policy-setting Federal Open Market Committee that the central bank might buy less than $600 billion, now that it appears Congress will OK a $900-billion program of tax cuts and spending to give the economy a boost. The FOMC statement contained no indication of any change in plans.

Critics see the Fed embarking on a bond buying binge that will lay a foundation for inflation that might be difficult to control and could lead to another recession. A cause for their concern is that interest rates started rising as the Fed launched its buying. The yield on 10-year Treasuries is approaching 3.5%, up more than a half percentage point in the past month. Yields on corporate bonds and 30-year fixed-rate mortgages are also rising.

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The White House economic team isn’t worried. Larry Summers, outgoing director of the National Economic Council, says he’d be concerned if the stock market had been plummeting during the past month. That would tell him the financial markets see inflation around the corner. Instead, stocks are up about 3%, suggesting the markets are anticipating a stronger economy in 2011.

Summers, after a speech Monday, acknowledged that the economy is picking up. But, he added, “it’s a mistake to declare victory too soon.” With unemployment so high, Summers said the greater threat is deflation, not inflation.

Inflation, as measured by the Consumer Price Index from last December until this month, is running about 1%. Next year the CPI will increase about 1.5%. Gross domestic product should increase about 3.5% in 2011, up from 2.8% this year.

Fed Chairman Ben Bernanke, also concerned about high unemployment, said in a rare television interview earlier this month that the Fed could tighten policy “in 15 minutes.” That’s how long an emergency phone call would take Fed officials to lift a key interest rate, which is near zero. The FOMC statement repeated that officials will keep the rate near zero “for an extended period.” Raising it depends on how strong the economy appears in the second half of next year.

By early next year, the FOMC will develop an "exit strategy" to reduce its Treasury holdings. That will be a form of gradual credit tightening. A rate hike will come later. So look for the fed funds rate to remain near zero, probably through 2011. Meanwhile, because of new fiscal stimulus in tandem with the Fed’s bond buying, long-term rates will be higher than previously expected. We expect the rate for 10-year Treasury notes to vacillate between 3.25% and 3.75% next year, ending 2011 near the higher part of that range.