Federal Reserve walking policy tightrope

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Published: August 10,2010

Tags: economy, Federal Reserve, fiscal policy, interest rates

WASHINGTON — Federal Reserve policymakers are pondering ways to jump-start the economic recovery. The trick: making sure whatever they do or say doesn’t rattle Wall Street.

U.S. stocks closed higher yesterday as investors anticipated reassuring words or action today by the chairman of the country’s central bank, Ben Bernanke and his colleagues on the Federal Open Market Committee. But early today, stock futures retreated, following overseas markets lower after China’s economy showed some signs of slowing down.

“There was some anticipation the Fed could announce additional liquidity measures like the purchase of bonds,” Craig Peckham, market strategist at Jefferies & Co. “It’s a little premature for the Fed to expand. We don’t think they’ll be any meaningful change in policy.”

A disappointing jobs report on Friday intensified pressure on Fed policymakers to consider new action aimed at stimulating economic growth. That report showed the unemployment rate stuck at 9.5 percent in July and a third straight month of anemic hiring from the private sector.

Researchers at the Federal Reserve Bank of San Francisco, in a paper yesterday, said there’s a “significant” chance the economy will tip back into recession in the next two years. However, such a backslide is unlikely to happen in the next few months, the researchers said.

Economists say Fed officials have a handful of options at their disposal to help prevent that from happening, but would likely consider from two options:

— Clarify that the Fed will keep short-term interest rates at record lows for as long as it takes to encourage more use of credit.

— Use the proceeds from the Fed’s investments in mortgage securities to buy government debt on a small scale. That could help drive down long-term interest rates.

Both steps would signal to markets that money could be borrowed cheaply for a longer period of time, giving businesses and individuals more confidence to finance major purchases. Still, economists doubt how much impact they would have. Interest rates are already at historic lows and that hasn’t generated more buying activity.

“Fed policymakers could consider token moves like this, but I don’t think are they ready to do a lot more,” said James O’Sullivan, global chief economist at MF Global.

A bolder step would be to restart programs undertaken during the financial crisis that involved large-scale purchasing of mortgage-backed securities and government debt.

But it could spook investors about the health of the economy. And a sell-off on Wall Street could prompt businesses and consumers to retreat further.

In 2009 and early 2010, the Fed bought $1.25 trillion in mortgage securities, $175 billion in mortgage debt from Fannie Mae and Freddie Mac, and $300 billion in government debt as part of two crisis-era programs.

At today’s meeting, the Fed is all but certain to leave its key bank lending rate between zero and 0.25 percent, where it has been since Dec. 2008.

There’s a chance the Fed could build on its pledge to hold this rate at record lows for an “extended period.”

That means rates on certain credit cards, home equity loans, some adjustable rate mortgages and other consumer loans will stay low. Commercial banks’ prime lending rate would stay at about 3.25 percent, the lowest point in decades.

The Fed’s focus again on energizing the recovery is a shift from earlier this year, when it was starting to lay out its “exit strategy” for eventually boosting interest rates.

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