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Will the Fed Buy Trillions in Treasuries?

Monetary policymakers are squaring off about what, if anything, to do to give the floundering economic recovery a shot in the arm.

Will a further effort to lower long-term interest rates help or hurt the economy? With the economic recovery sputtering, that’s the key issue in a fierce policy battle going on behind the closed doors of the Federal Reserve. The Fed’s benchmark short-term rate is already near zero and has been since December 2008.

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Fed Chairman Ben Bernanke and his allies say cutting long-term rates will help increase consumer spending, business investment and job growth. So Team Bernanke is leading a push for the Fed to buy long-term Treasuries—a lot of them, up to $1 trillion worth. The theory is that such heavy buying will push bond rates lower while boosting reserves that banks hold in cash. The aim is for banks to get fed up with the paltry returns they’re getting and go after higher rates by making loans to businesses that want to expand and households that want to buy a house or refinance.

Opponents argue that large Treasury purchases won’t work and are dangerous to boot. Unusually outspoken for members of the Fed, this group is arguing in speeches and comments that previous central bank purchases of $1.7 trillion in Treasuries and mortgage-backed bonds haven’t done much to spark economic growth. They point out that there’s already plenty of cheap credit around, and adding more will only spark inflation down the road.

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While critics think Bernanke is jumping the gun, the chairman doesn’t want to take the chance that he moves too slowly. The shadow of another Great Depression hangs over his thoughts. He has the votes to carry the day when the rate-setting Federal Open Market Committee next meets, Nov. 2-3. But, in a nod to Bernanke’s critics, the Fed is likely to approach the purchases in a measured way.

Odds are it will announce a modest purchase of $100 billion or so a month, with larger Treasury purchases if needed to lower unemployment. Why go slow? Launching a big buy could spook traders. If they decide to shun bonds, interest rates won’t fall and that would defeat the Fed’s efforts. Also, a large purchase could scare the public and cause a steep decline in stocks—also contrary to the Fed’s goals.

Ironically, the bond market may have already anticipated and reacted to the Fed’s plans. The yield on 10-year Treasury notes has fallen a quarter of one percentage point in the month since word of Bernanke’s thinking seeped out. That means if the Fed doesn’t follow through with this course, long-term interest rates are likely to creep higher.

Look to four markets for an early indication of whether the program will succeed, once the Fed announces its plan. Here’s what to watch for:

• A dip in long-term Treasury yields from their current rate of about 2.5% • A stock market increase • A narrowing of the spread between Treasuries and corporate bonds • And a modest decline in the value of the dollar.

Each would boost the confidence of consumers and businesses, lead to more spending and ultimately, the creation of more jobs.

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