The Federal Reserve next week is expected to give the economy the equivalent of a B-12 shot.
But many economists question whether it will be enough to perk up a listless recovery. Others say it ultimately will lead to rampant inflation.
Based on its signals since August, the central bank Wednesday will likely announce a new round of government bond purchases to lower long-term interest rates and stimulate economic growth. It would be the Fed's most aggressive bid to rev up the economy since it bought $1.7 trillion in bonds starting in early 2009 in the financial crisis.
Two-thirds of 33 economists who provided an estimate to USA TODAY expect the Fed to buy $400 billion to $750 billion in Treasury notes or other assets. Many say the purchases will be made in the next six to eight months. Expectations that it might snap up $1 trillion or more have been dampened lately, though it's possible. The goal: drive up the prices of long-term bonds, which pushes down yields. That, in turn, pulls down rates on mortgages and other loans, spurring consumers to buy homes and cars, and businesses to invest and hire workers.
Speculation about the program in recent months already has driven up stocks and lowered interest rates. The yield on the 10-year Treasury bond fell from 2.86% on Aug. 9 — when the Fed first telegraphed its intentions — to as low as 2.38% before rising to 2.66% Thursday. The S&P 500-stock index is up 4.7%. There's a good chance rates won't move much more when the Fed announces the purchases unless it spends at least $1 trillion, says MF Global chief economist Jim O'Sullivan.
The Fed feels compelled to act because the upturn from the recession remains painfully slow. Unemployment is near 10%. Economists expect the government Friday to report that the economy grew 2% in the third quarter — not enough to keep the 9.6% jobless rate from rising. New York Fed President William Dudley last week called today's unemployment and too-low inflation "unacceptable." Fed Chairman Ben Bernanke said last month there appears "to be a case for further action."
Typically, the Fed sparks growth by trimming its benchmark short-term rate. But that's been near zero since the financial crisis. The Fed in early 2009 launched an unprecedented program — buying $1.42 trillion in mortgage-backed securities and related debt and $300 billion in Treasuries. Mortgage rates fell as much as a percentage point.
Back then, the Fed was pumping cash into markets frozen by fear. Now, both banks and corporations have gobs of cash. Yet, many homeowners don't qualify to refinance their mortgages — which would put more cash in their pockets — as their homes are worth less than their mortgages, says Paul Ashworth of Capital Economics. Businesses, he adds, "are too cautious to hire or invest."
Philadelphia Fed President Charles Plosser, a non-voting member of the Fed's policymaking committee, has said it's "difficult" to see how asset purchases will have much impact on employment.
But Mark Zandi, chief economist of Moody's Analytics says the Fed has little choice; the risk of slipping back into recession is "uncomfortably high."
Zandi estimates $500 billion in Treasury purchases would boost economic growth next year to 2.7% from 2.4%, create 250,000 jobs and trim unemployment by two-tenths of a percentage point. Brian Bethune of IHS Global Insight says it could have a bigger effect by raising investor confidence and pushing down the dollar, which boosts exports.
Some say the modest gain is not worth the risk of inflation. It will be tough for the Fed to raise interest rates to head off inflation as the economy heats up when banks are sitting on so much of the Fed's cheap money. Kansas City Fed President Thomas Hoenig last week said of the Fed's plan that "you are making a bargain, I'm afraid, with the devil."
While the Fed may well do what many expect on Wednesday, it could also:
•Adjust the size of the program. Zandi expects the Fed to leave the door open to further asset purchases if the economy doesn't pick up in six months and ultimately buy $1 trillion by mid- 2011. That could boost growth to 3% next year and cut the jobless rate by half a percentage point.
"If you're going to do something, do something big," Ashworth says.
Alternatively, the Fed could buy $100 billion of assets and decide whether to do more when it meets every six weeks. That would placate Fed inflation hawks and make it easier to shelve the program if the recovery heats up. O'Sullivan says it's unlikely: It would disappoint investors, who would sell bonds, lowering prices and raising rates.
•Signal low interest rates for a longer time. The Fed has indicated short-term rates likely would stay low "for an extended period" — a phrase widely interpreted to mean about six months. It could suggest rates would stay low even longer in a bid to further drive down Treasury yields. Bethune says it could instead drive up rates as investors anticipate inflation. Bernanke has said it could be difficult to convey the Fed's intent "with sufficient precision."
•Allow higher inflation. The Fed could signal it's prepared to let inflation exceed its target of 2% a year for a brief period since it's been so low. Higher inflation could spur consumer purchases on fears prices will soon rise and on lower real — or inflation-adjusted — interest rates. But Bethune says communicating that policy to the public would be tricky.
•Cut the interest rate on reserves banks hold at the Fed. This could prompt banks to use that money for lending instead to get a bigger return. But the rate is already quite low. Bernanke has said the effect would be "relatively small."
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