Questions and answers about the Fed's decision

AP News
|
Posted: Sep 21, 2011 6:39 PM
Questions and answers about the Fed's decision

The Federal Reserve unveiled a two-pronged effort Wednesday to boost the economy. It said it will sell $400 billion in short-term Treasurys it owns and replace them with longer-term Treasurys. And it will reinvest principal payments from its mortgage-backed securities. Both steps are intended to cut long-term interest rates and increase growth.

Here are some questions and answers about the Fed's announcement:

Q. What's the Fed trying to achieve?

A. It wants to lower interest rates for consumers and businesses. Chairman Ben Bernanke and a majority on the policymaking committee hope lower rates will spur borrowing and spending. Lower mortgage and auto-loan rates could increase home and car sales and business investment. And lower bond rates could lift stock prices. In part, that's because low Treasury yields cause some people to shift money into stocks. Higher stock prices could boost the wealth and confidence of individuals and businesses. Ideally, spending would then rise, lifting incomes, profits and economic growth.

Q. How much would this help the economy?

A. Probably only a little. Even if the Fed's plan lowers rates, it's unlikely by itself to reduce unemployment much or accelerate economic growth. Rates on mortgages and other loans are already super-low. Yet consumers are reluctant to take on new debt. Banks have tightened lending standards. Small companies are hobbled by weak sales. Still, most analysts think the Fed's move is worth trying because the economy is barely growing, and unemployment is 9.1 percent. It might also boost confidence. Consumer confidence has plunged to recession-era lows, and the Fed wants to prevent that from translating into less spending.

Q. How will the plan work?

A. The Fed will sell $400 billion in Treasurys that mature in less than three years. And it will replace them with Treasurys that mature in six to 30 years. The sales will be completed by June. The Fed's purchases will help push up prices of long-term Treasurys. In response, their yields will fall. So will those for other loans, too. The yield on the 10-year Treasury note, for example, is used as a benchmark rate for mortgages and other consumer loans. The New York Fed will conduct the sales and purchases through the group of 20 large banks it calls its primary dealers.

Q. Has anything like this been done before?

A. Yes. In 1961, just weeks after the inauguration of President John F. Kennedy, the Fed took similar steps. It named its program Operation Nudge, the idea being to nudge long-term rates lower. But at the time, Chubby Checker's record "The Twist" was all the rage, and the name "Operation Twist" stuck instead. Checker had performed the song on American Bandstand in July 1960, and it hit No. 1 later that year. Research has found that the 1961 version of Operation Twist pushed down long-term rates by about two-tenths of a percentage point. That might not sound like much. But the San Francisco Federal Reserve Bank has concluded that it's similar to the impact if the Fed were to cut the short-term rate it controls by a full point. Right now, the Fed can't cut that rate at all; it's already near zero.

Q. Did the Fed do anything else Wednesday?

A. Yes, it said it will reinvest the proceeds from its $900 billion portfolio of mortgage-backed securities into new mortgage-backed securities. That is also intended to keep mortgage rates low.

Q. Why did the Fed decide to take these steps?

A. Partly because they don't require it to create more money. Since the financial crisis erupted in 2008, the Fed has bought nearly $2 trillion in Treasurys and mortgage-backed securities _ all with newly created money. That's earned Bernanke scorching criticism from leading GOP presidential candidates, who say those moves will boost inflation. By essentially printing more dollars, the Fed expands the money supply. And more dollars chasing the same amount of goods can raise prices. The Fed must wind down its portfolio eventually, which will be risky because selling bonds might push up interest rates. Also, three members of the Fed's policymaking committee dissented from Wednesday's move. That suggested that Bernanke might not have the support to do much more. When the same three members dissented last month, it was the most dissents since 1992.