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Fed to Buy Treasuries With Maturing Mortgage Debt in Bid to Revive Economy

Tuesday, 10 Aug 2010 02:13 PM

 

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The Federal Reserve on Tuesday took fresh steps to lower borrowing costs amid a softening economic recovery, announcing it would use proceeds from its maturing mortgage bonds to buy more government debt.

The decision to reinvest proceeds from the more than $1.3 trillion in mortgage-related debt the Fed holds, an effort to keep market-set borrowing costs down, represents a significant policy shift.

Just a few months ago, the central bank had been avidly debating an exit strategy from the extraordinary stimulus delivered during the financial crisis.

"To help support the economic recovery in a context of price stability, the committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities," the Fed said in a statement.

The move was somewhat surprising.

Although many analysts and investors had expected the Fed to announce it was reinvesting the mortgage proceeds, most had thought it would buy more mortgage debt instead of government bonds.

Some analysts believe the Fed will end up having to go further in coming months and restart its shuttered program of outright asset purchases.

"The Fed is a step closer to reviving its program, but it will likely take somewhat slower growth to push it off the fence," said Sal Guatieri, senior economist at BMO Capital Markets.

The Fed also left benchmark overnight interest rates steady in a zero to 0.25 percent range, and renewed its pledge to keep them low for an extended period.

U.S. stocks trimmed losses on the announcement, while prices for U.S. government debt rose, with the 30-year bond gaining more than a point. The dollar fell against both the euro and the yen.

In their statement at the close of a one-day meeting, Fed officials offered a gloomier outlook for the economy, saying the recovery in output and employment "has slowed in recent months." When it last met in late June, it said the recovery was "proceeding."

Kansas City Federal Reserve Bank President Thomas Hoenig dissented for a fifth straight meeting over the Fed's vow to keep rates low for a long time.

However, he also was more optimistic about the economy than his colleagues, saying it was "recovering modestly," and that he did not think the Fed needed to keep its balance sheet from shrinking.

Data has been decidedly weak since the U.S. central bank's last meeting in late June. Consumer spending has softened and manufacturing appears to be losing steam. The unemployment rate, meanwhile, is stuck at 9.5 percent.

With U.S. interest rates already effectively at zero, the central bank has run out of easy policy options.

While the decision to reinvest proceeds that would otherwise roll off its balance sheet was only a small move, it could open the door to further steps in the future.

The Fed could lower the rate it pays banks to park their excess reserves at the central bank, currently at an already low 0.25 percent, or somehow redoubling its already-stated commitment to keep interest rates low.

It could also relaunch its bond-buying program if it felt the recovery was about to stall.

This policy would not come without risks, however.

It could expose the central bank to accusations it is printing money to help the fund the large U.S. government budget deficits, something Fed officials have said they would never do.

The idea behind further assets purchases would be to prevent a deflationary cycle of falling prices and depressed consumption from taking hold.

Consumer prices outside food and energy rose just 0.9 percent in the 12 months through June, holding for a third straight month at the lowest level seen since January 1966.

Hourly compensation for U.S. workers fell at an annual rate of 0.7 percent in the second quarter, the government said on Tuesday in a report that underscored the lack of an inflationary threat.

A San Francisco Fed study released Monday found a significant chance the economy would slip back into recession in the next two years, while a monthly survey of economists found that 55 percent believe the Fed will take more steps to support growth in the next 12 months.

"They have the ammo. The question is how effective it is," said Jay Bryson, global economist at Wells Fargo Securities in Charlotte, North Carolina.

The Bank of Japan, which also met Tuesday, decided to hold off on any further easing measures despite a rise in the yen, which has rallied near record highs on expectations of further measures by the Fed.

© 2014 Thomson/Reuters. All rights reserved.

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