By Tom Petruno

RISMEDIA, November 8, 2010—(MCT)—The Federal Reserve has announced a new “quantitative easing” plan aimed at bolstering the economy. So what’s quantitative easing? The term is a mouthful, but is simple in execution: The central bank plans to boost its purchases of U.S. Treasury bonds in the open market, hoping to push longer-term interest rates lower, or at least keep them from rising significantly.

The Fed has already “eased” its monetary policy—tried to get more money into the economy—by slashing short-term interest rates. (Raising rates is known as tightening).

But short-term rates are already near zero. So the Fed now is focused on longer-term rates.

The “quantitative” refers to a specific quantity of money—in this case, $600 billion, which is the sum of Treasury debt the Fed said it would buy by next June, on top of about $300 billion of purchases already planned.

Here’s a primer on the program and what it may mean for the economy and financial markets:

Q: Where does the money come from?
A:
The Fed literally creates it from thin air, which it’s permitted to do as the nation’s central bank. But instead of printing actual cash, the Fed credits the accounts of banks and brokerages from which it buys Treasury securities. The net effect is to remove those bonds from the market, hold them on the Fed’s books, and replace them with money that can circulate into the financial system and the real economy.

Q: How does this affect financial markets?
A:
By standing ready to buy a large quantity of Treasuries each month, the Fed becomes a major force in determining the market interest rates on the bonds. If it can keep longer-term Treasury yields depressed, the Fed can influence other longer-term interest rates—such as on mortgages and corporate bonds—because those rates tend to follow the direction of Treasury yields.

What’s more, by keeping rates down and channeling cash to investors for their Treasuries, the Fed hopes to encourage lenders and investors to put that money to work in the economy—for example, by lending to businesses or by buying stocks.

Q: How does the Fed know this plan will work as intended?
A:
It doesn’t—something Chairman Ben S. Bernanke has acknowledged. The Fed may get fresh cash to banks, but there’s no guarantee that more lending will result.

But in terms of influencing interest rates, the Fed had some success with a previous round of quantitative easing. The central bank bought $1.75 trillion of mortgage-backed bonds and Treasuries from December 2008 to March 2010, a program that was credited with helping to keep mortgage rates subdued.

And in August, the Fed began using income from its mortgage bonds to buy Treasuries. Those purchases, and anticipation of the new program, helped push longer-term interest rates lower across the board in recent months.

The 10-year Treasury note yield dropped from 2.96% on Aug. 2 to a 21-month low of 2.38% in mid-October.

Mortgage rates, in turn, have fallen to generational lows, with the average 30-year loan rate sliding to 4.19% by mid-October from 4.5% in early August.

Q: Might interest rates have fallen as low as they’re going to go, even with new Fed bond purchases?
A:
That’s possible. The Fed cannot directly control longer-term rates; the bond market is simply too big.

What’s more, the Fed probably would be happy to see interest rates rise to some degree if the reason is that the economy is improving, boosting business and consumer demand for loans.

In its statement Wednesday, the Fed said it would “adjust the program as needed” depending on the economy’s performance.

Some analysts believe the Fed’s main message is that it wants to foster stability in longer-term rates, not necessarily sharply lower rates.

“They want to assure that the economic landscape is pro-growth,” said Tom Tucci, head of Treasury bond trading at RBC Capital Markets in New York. “They want people to feel comfortable spending money.”

Q: What are the risks in the Fed’s plan?
A
: There are several, and they aren’t minor.

The central bank is supposed to be independent of the government, but Fed purchases of Treasury bonds open the Fed to criticism that it is eagerly financing the government’s massive budget deficits, which totaled $1.3 trillion in the recent fiscal year alone.

Bill Gross, co-head of bond fund giant Pimco in Newport Beach, Calif., has criticized the Fed’s bond-buying program as a “Ponzi scheme.”

The Fed also risks driving the dollar’s value sharply lower by flooding the world with more greenbacks. Although a weaker dollar helps make U.S. exports cheaper abroad, the Fed wouldn’t want to encourage massive dumping of dollars by foreign investors who are tired of seeing the currency devalued.

After the Fed’s announcement, an index of the dollar’s value against six other major currencies, including the yen and the euro, fell 0.5% to its lowest level since December. The index has tumbled 13.6% since early June.

Finally, if the Fed succeeds in pumping more money into the economy, it risks stoking inflation that could get out of control.

To an extent, the Fed actually wants higher inflation: Bernanke and other Fed policymakers have said in recent months that they believe inflation has fallen too low, putting the economy at risk of sliding into deflation.

The “core” consumer price index, which excludes food and energy, was up just 0.8% in September from a year earlier, the smallest increase since 1961.

But the Fed can’t control where money goes after its bond purchases infuse banks and investors with fresh cash. Some economists worry that the Fed is already fueling inflation in commodities and emerging-market stocks, as investors look for alternatives to low-yielding Treasury bonds.

A price index tracking 19 major commodities has surged 15.5% since the end of August. “Inflation is showing up—just not in the places the Fed wants,” said Drew Matus, an economist at UBS Securities in New York.

(c) 2010, Los Angeles Times.

Distributed by McClatchy-Tribune Information Services.

http://rismedia.com/2010-11-07/quantitative-easing-what-it-may-mean-for-the-economy-and-financial-markets/