Bernanke out of moves, critics say

How many arrows left in Fed’s quiver?

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With interest rates near zero and the Federal Reserve already owning a large share of the mortgage and Treasury securities markets, many investors fear the central bank may be out of ammunition should the economy take a serious turn for the worse.

But Fed-watchers say the central bank, despite its dwindling options, has proved adept recently at manipulating markets to generate at least a psychological boost - perhaps all the economy needs if it is experiencing only a temporary “soft patch,” as the Fed maintains.

The Fed got markets churning at its last meeting in August, when it decided to reinvest mortgage securities that are coming due in its $2 trillion portfolio, putting the money in an array of Treasury securities. That seemingly small gesture will infuse between $14 billion and $25 billion a month into the world’s largest securities market - a drop in the bucket, given the trillions of dollars of turnover there each day.

But Fed Chairman Ben S. Bernanke subsequently promised more sweeping Fed measures and bond purchases if the economy seemed to be sliding back toward recession.

Andrew B. Busch, strategist at BMO Capital Markets, said he is skeptical that the Fed can do much more to save an economy that has lost considerable momentum after a year of growth induced by extreme government stimulus from the Fed and Congress.

“If the Fed feels the economy has materially softened, what can they do about it?” he asked. “The Fed’s balance sheet and emergency easing have gone to the limit of what they can do.”

Any further heroic efforts by the Fed would only trigger a “one-day equity rally and then a big fade as the markets rightly grasp there is little they can do to generate growth at this point,” he said.

Charles Biderman, chief executive of TrimTabs Investment Research, said Mr. Bernanke’s recent pledge to do whatever it takes to keep the economy above water “reeks of desperation” as it only highlights the fact that the central bank’s previous, massive efforts have failed so far to produce a convincing recovery in the housing market, jobs market or overall economy.

But other analysts point out that the Fed moves have already been helpful by triggering an unexpectedly powerful rally in the bond market that has pushed mortgage rates into record low territory. Freddie Mac said Thursday that the average 30-year mortgage rate sank for an 11th consecutive week to an unprecedented 4.32 percent.

While critics point out that the ultralow rates so far have not prevented another collapse in home sales this summer, they have spawned a minor home-refinancing boom. Brian Bethune, economist at IHS Global Insight, credits the Fed’s “relatively minor” moves, which had a big impact on the markets.

The extremely low rates are assisting consumers and businesses as they seek to get loans, pay debts and repair their finances - a painful but necessary deleveraging process that happens in every recession and that will enable people to spend more in the future, he said.

Moreover, the Fed’s seemingly small steps kicked off a “virtuous cycle” where the Fed’s gradual purchases of Treasury securities drives interest rates lower and prompts more mortgage refinancings. The mortgage refinancings, in turn, prompt the early redemption of the Fed’s mortgage securities, causing the Fed to reinvest more in Treasuries, repeating the cycle, he said.

All told, IHS estimates that by the end of next year, the Fed will have purchased at least $400 billion more Treasury securities through these gradual interventions, driving interest rates lower without taking any further action. The Fed currently already owns more than $700 billion of Treasury securities, making it the third-largest owner of U.S. debt behind China and Japan.

Richard Berner, chief U.S. economist at Morgan Stanley, also attributed a significant drop in interest rates to the Fed’s recent moves, which sent the yields on Treasury’s 10-year bonds to extraordinarily low levels around 2.5 percent.

“The change in the Fed’s reinvestment policy is more than a symbolic shift, because it both avoids a passive shrinkage of the Fed’s balance sheet and tees up the markets for a more aggressive purchase program at some point down the road,” if necessary, he said.

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