19 March 2009

U.S. Central Bank Moves to Pump Up Economy

Massive purchase of assets dwarfs previous actions

The Dow Jones Industrial Average stock index moved up 91 points as investors responded to the news about the Federal Reserve’s action.

Washington — With its interest rate hovering around zero, the Federal Reserve — the U.S. central bank — has resorted to unconventional measures to infuse more than $1 trillion into the ailing financial system.

The bank announced March 18 it will purchase $750 billion in mortgage-backed securities and $300 billion in long-term Treasury bonds to bring down costs of home-purchase financing and other types of loans as well as to reduce long-term interest rates.

The Federal Reserve normally uses the key interest rate — the federal funds rate — to regulate the supply of money in the economy. However, having reduced this rate virtually to zero, the Federal Reserve had no option but to take exceptional steps to revive lending and mitigate the recession.

The bank pursued unconventional policies throughout 2008 in response to a global financial crisis and the recession stemming from it. Since September 2008, the bank’s lending programs doubled the size of its balance sheet to $1.8 trillion from $900 billion. But the scope and size of its latest intervention in the market dwarf any single step taken so far. The actions announced March 18 will expand its purchases to $3 trillion. The bank will print more money to pay for them. (See “2008: The Year the Fed Steamed into Uncharted Waters.”)

The bank said in a statement the U.S. economy continues to shrink and described the near-term outlook as “weak.”

The statement said the bank will leave the federal funds interest rate in a range between zero and 0.25 percent and said it is likely to keep the rate at that level for “an extended period.” It also suggested it will soon expand a new program to finance consumer and business lending.

Following the Federal Reserve’s announcement, the Dow Jones Industrial Average stock index rose 91 points and yields on long-term Treasury bonds dropped significantly. Market analysts expect fixed-rate home loans to fall soon.

Although the bank’s actions may ease and shorten the recession, they carry risks, according to analysts. The value of the U.S. currency dropped sharply yesterday on the expectation of more dollars flooding the market. In recent weeks, the dollar had been rising against major currencies as international investors sought the relative safety of dollar-denominated assets such as Treasury bonds. Another less immediate risk relates to the Federal Reserve’s ability to remove the money from the system once the economy starts to improve. If the bank does not sell massive values of assets adeptly, it may expose the economy to high inflation.

The full text of the bank’s statement is available on the Federal Reserve Web site.