Expectations high for Fed to announce major action

September 12, 2012 - 4:36 PM

WASHINGTON (AP) — If the world's investors are right, the Federal Reserve is about to take a bold new step to try to invigorate the U.S. economy.

And many expect the Fed to unleash its most potent weapon: a third round of bond purchases meant to ease long-term interest rates and spur borrowing and spending. It's called "quantitative easing," or QE.

Others foresee a more measured response when the Fed ends a two-day policy meeting Thursday. They think it will extend its timetable for any rise in record-low short-term rates beyond the current target of late 2014 at the earliest.

Fed officials began their discussions Wednesday and will end with an announcement of any decision around 12:30 p.m. Eastern time. Later, Chairman Ben Bernanke will hold his quarterly news conference.

The stock market edged higher Wednesday, partly in anticipation of Fed action and after the highest court in Germany cleared the way for that country to contribute to Europe's rescue fund to help indebted governments.

The Fed is facing pressure to act now because the U.S. economy is still growing too slowly to reduce high unemployment. The unemployment rate has topped 8 percent every month since the Great Recession officially ended more than three years ago.

In August, job growth slowed sharply. The unemployment rate did fall to 8.1 percent from 8.3 percent. But that was because many Americans stopped looking for work, so they were no longer counted as unemployed.

Chronic high unemployment was a theme Bernanke spotlighted in a speech to an economic conference in Jackson Hole, Wyo., late last month. Bernanke argued that QE and other unorthodox Fed actions had helped ease borrowing costs and boosted stock prices.

Higher stock prices increase Americans' wealth and confidence and typically lead individuals and businesses to spend more.

In his speech, Bernanke cited research showing that the two previous rounds of QE had created 2 million jobs and accelerated economic growth. Still, he said persistently weak hiring remains "a grave concern" that inflicts "enormous suffering."

His remarks sent a clear signal that the Fed will do more.

"He had a sense of urgency in that Jackson Hole speech," said David Jones, chief economist at DMJ Advisors. "I think he is convinced that there is a need to do something."

Some critics, inside and outside the Fed, remain opposed to further bond buying. They fear that by pumping so much cash into the financial system, the Fed is raising the risk of high inflation in the future. And many don't think more bond purchases would help anyway because interest rates are already near record lows.

Some economists who doubt the Fed is about to begin more bond buying say the European Central Bank has eased some pressure on the Fed. Last week, the ECB announced a plan to buy unlimited amounts of government bonds to help lower borrowing costs for countries struggling with debts.

If the ECB's plan succeeds in bolstering Europe, the U.S. economy could benefit, too. Europe's financial crisis and recession have slowed the U.S. economy, in part by reducing European purchases of U.S. goods.

Some also think the Fed might be reluctant to launch a bond-buying program in the final two months of the presidential campaign. Many Republicans have been critical of the Fed's unconventional methods to boost the economy. After the financial crisis struck in 2008, the Fed bought more than $2 trillion in Treasury and mortgage-backed securities.

The Fed "is already a campaign issue, and enlarging its balance sheet will make it even more of one," argues Vincent Reinhart, chief economist at Morgan Stanley and a former top economist at the Fed. Reinhart thinks the Fed will prefer to wait until at least December before announcing more bond buying.

By then, he says, the Fed will have reviewed more employment data. The effect of Europe's debt crisis on the U.S. economy will be better known. And Congress' plans for addressing a U.S. fiscal crisis at year's end will be clearer. Without a budget deal, higher taxes and deep spending cuts will kick in next year.

If the Fed takes the more modest step Thursday of extending its timetable for any rate increase, many analysts think it would push its target date to mid-2015. The goal would be to lower borrowing rates by assuring investors that short-term rates will likely stay near zero even longer than previously thought.

Yet Bernanke's remarks in Jackson Hole about unemployment were so downbeat, and his defense of Fed bond purchases so strong, that many economists suspect a bond-buying program will be unveiled Thursday.

So do investors. In part because of anticipation of a QE3, they've boosted the Dow Jones industrial average nearly 2 percent in September, a month that's typically weak for stocks. On Tuesday, the Dow rose 69 points. And Treasury yields have dropped on expectations that a new Fed bond-purchase program would lower interest rates.

The concern Bernanke expressed in Jackson Hole followed a Fed policy meeting in which many officials felt more Fed action would "likely be warranted fairly soon" unless there was a "substantial and sustainable strengthening in the pace of the economic recovery," according to minutes of the meeting.

Friday's report that U.S. employers cut back sharply on hiring in August dimmed hopes of a strengthening job market.

If the Fed does unveil QE3, some economists think it might differ from the previous bond-buying programs. With its earlier purchases, the Fed announced a dollar amount and a time frame for the bonds it planned to buy.

This time, any new bond-purchase program might be more open-ended. Three regional Fed bank presidents — Eric Rosengren of Boston, James Bullard of St. Louis and Charles Evans of Chicago — have expressed openness to a program in which the Fed would buy bonds until the economy improved significantly and unemployment fell consistently — as long as inflation remained tame.

None of those officials now have a vote on the Fed's policy committee. But they take part in the committee discussions that would allow them to push the idea.

Jones of DMJ Advisors says he thinks open-ended bond purchases will be discussed at this week's policy meeting. Still, he expects the Fed to announce a more conventional bond-buying program of around $500 billion. That would be less than the $600 billion in bonds in QE2 and well below the $1.75 trillion in QE1.

In light of Bernanke's recent comments, Jones doesn't think the Fed wants to delay further support for the economy until the election is over. Neither does Diane Swonk, chief economist at Mesirow Financial.

"This will be an effort on the part of Fed officials to pull out as much firepower as they can," Swonk said. "They are trying for as much shock and awe as they can muster."