- The Washington Times - Thursday, August 13, 2009

After more than a year of pumping money into financial markets to buoy the troubled economy, the Federal Reserve began to reverse course Wednesday, taking the first step to withdraw some of those trillions of dollars by announcing that it will phase out an unprecedented program to purchase some of the government’s own debt.

By ending the $300 billion program to purchase U.S. Treasury bonds, instituted in a bid to drive down interest rates at the height of last winter’s market meltdown, the Fed bowed to worries about inflation and signaled that it thinks the worst of the recession is over.

The announcement caused an immediate uptick in the rates on Treasury bonds and eventually could drive up 30-year mortgage rates, but it came as a relief to many global investors who feared the Fed’s program amounted to printing money to finance the soaring national debt, raising the risk of inflation.

With the debt surging by as much as $2 trillion this year driven by the recession and huge economic stimulus programs enacted by Congress, the program appeared to some like the tactics used by banana republics that regularly print money to cover government deficits - causing hyperinflation and the degradation of the national currency. Many global traders cited the Fed’s program as they bet on a fall in the dollar in recent months and bid up the price of key commodities such as oil that are priced in dollars.

“To start the program in the first place was a clear policy error,” said Harm Bandholz, an economist at Unicredit Markets. “An increasing number of Fed officials had gotten more and more concerned about the perception that the federal debt was being monetized. Those members were afraid that this public concern about monetization could have adverse implications for inflation expectations.”



Moreover, Fed officials came to the conclusion that the program was not clearly achieving its intended purpose of lowering the rates on Treasury bonds, 30-year mortgages and other long-term loans. Rates on most of those instruments have climbed significantly since touching all-time lows immediately after the Fed began the program in March. The yields on Treasury bonds rose Wednesday after the Fed’s action.

“The Treasury program has not been particularly successful,” said Sung Won Sohn, an economics professor at California State University at Channel Islands. “It may have contributed to inflation psychology in the marketplace, raising the bond yield.”

Kurt Karl, chief U.S. economist at Swiss Re, said foreign investors worried that the Fed’s policies would spark inflation should be comforted by the move to phase out the bond-buying program.

“Inflation will not be a problem. The Fed knows how to exit from the quantitative easing programs. This should not be a concern,” he said.

The Fed stressed that the move could withdraw the stimulative measure in light of the economy’s recent improvement. It cited a “leveling out” of economic activity and much improved financial conditions in recent months because of strong rallies in the stock and credit markets.

“Many of the Fed’s emergency initiatives were rescue measures enacted for a sinking economy. Now that the economic recession has seemingly stabilized, the Fed can afford to pull in a few of its life rafts,” said Richard Yamarone, economist with Argus Research Corp.

The Fed’s rate-setting committee also said it would maintain short-term interest rates - which are directly controlled by the Fed - close to zero to continue to nurse the economy back to health. With the economy only beginning to recover from the longest and most severe recession in modern times, most economists expect the Fed to keep short-term rates near zero well into next year, until it is sure the economy is in a sustained recovery.

“With unemployment likely to linger at uncomfortably high levels for a sustained period of time, it’s a safe bet the Fed finds comfort in keeping a few life preservers in the water until the coast is clear,” Mr. Yamarone said.

The Fed’s primary tool for regulating the economy is the federal funds rate, which is the rate that banks charge one another for overnight loans. The Fed moves the rate up and down by increasing or decreasing the money supply through purchases and sales of short-term Treasury securities nearly every day in trading on Wall Street.

The Treasury bond-buying program announced early this year departed from the Fed’s usual procedures in that it aimed to start acquiring long-term bonds with the goal of drawing down long-term rates, which usually are determined in financial markets and are not directly controlled by the Fed.

In phasing out the program, the Fed said it would gradually complete its planned $300 billion of Treasury purchases by October, at which point the program would end. But it said it would continue a separate program of purchasing up to $1.25 trillion in Fannie Mae and Freddie Mac mortgage securities, which has been more successful at helping to keep mortgage rates low.

Mr. Sohn said the decision to keep the mortgage-buying program in place shows the Fed has not given up on trying to influence the level of long-term interest rates to ensure that the budding recovery in the housing market continues.

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