What the Fed's $600 Billion Plan Really Means

The Federal Reserve Wednesday announced its latest effort to spur economic growth: a plan to purchase up to $600 billion of government bonds through June 2011.

Why is the Federal Reserve buying bonds?

It wants to lower interest rates, in the hopes that doing so will loosen the supply of credit and spur more economic activity. The central bank’s main tool for reducing rates is to slash the short-term overnight lending that banks charge to one another, the so-called Federal Funds rate. Bring short-term rates down, and long-term rates tend to follow. In normal times, that’s as far as the Fed usually goes. In the past three years, the Fed has reduced the Fed Funds target rate 10 times, from 5.25 percent to between zero and .25 percent. It’s been at that extremely low level since the fall of 2008.

Once the Fed Funds rate can’t get any lower, what else can the Fed do?

It can buy assets, or engage in what’s known as quantitative easing (QE). Adjusting the Fed Funds directly influences short-term rates. The Fed can also influence long-term rates by purchasing (or selling) long-term debt in the open market. When lots of people -- or one big buyer -- buy bonds at the same time, it drives prices up and interest rates down. As the nation’s central bank, the Fed can create money and simply announce that it will buy large quantities of bonds.

Hasn’t it done something like that already?

Yes. In its first effort at quantitative easing, the Fed in 2009 and early 2010 bought more than $1 trillion in mortgage-backed securities in an effort to reduce interest rates on home mortgages. Partially in response to the purchases, mortgage rates fell to historically low levels.

So what is it doing now?

This is a smaller effort. The Fed says that, as part of an effort to lower interest rates, it will buy $600 billion of Treasury bonds between now and the end of June 2011, at a rate of about $75 billion per month.

But the market reacted at first by pushing interest rates on the 10-year and 30-year government bonds higher. What gives?

The Fed said it would focus its buying power on bonds that mature in four to six years,

with more than 85 percent of the purchases concentrated in bonds that mature between 2.5 and 10 years from now. Investors were expecting that the Fed might spend more on longer-dated Treasury securities, and sold them once they learned of the Fed’s plans.

Will these purchases alone guarantee that interest rates will fall?

No. Investors love to repeat the mantra: Don’t fight the Fed. But as much firepower as the central bank possesses, the Fed isn’t the only powerful economic force in the world. And interest rates can be impacted by all sorts of factors. If China’s central bank cuts back sharply on its purchases of U.S. government bonds, interest rates will rise. Investors’ attitudes about the pace of growth, or inflation, play an important role in determining market interest rates.

Whom is this good for?

In theory, it should be good news for borrowers of all types, but in particular corporate ones. If mid-term borrowing costs fall across the board, more companies should be able to refinance existing debt at lower levels, or take on new debt at lower cost. In theory, lower rates for big borrowers (i.e. banks) should mean credit will be more plentiful, or available on easier terms to businesses and individuals. And of course, any move the Fed makes to reduce interest rates tends to be a positive for stocks.

Whom is this bad for?

Savers. In this low-interest-rate environment, people who live on fixed incomes have had great difficulty finding safe instruments that deliver significant returns. To the extent this effort succeeds at holding longer-term interest down, it makes that task all the more difficult.

Government bonds are risk-free investments. What are the risks the Fed runs by taking more government bonds onto its balance sheet?

There are a couple of risks. First, low interest rates and the expansion of the Fed’s balance sheet tend to weaken the dollar. But the second -- and larger -- risk is that it won’t work. Interest rates are already exceedingly low, and it’s unclear how lowering them a bit more will induce companies and individuals to change their behavior significantly. Quantitative easing doesn’t directly address the underlying problem in the economy: that demand is too weak to fuel satisfactory growth. To combat weak demand, fiscal policy -- e.g., tax cuts, rebates, a payroll tax holiday, jobs program -- is often more effective than monetary policy. But fiscal policy remains paralyzed. Ideally, fiscal and monetary policy should be working in tandem. In the current situation, Bernanke is cranking up the volume while the political system is sitting on its hands. Imagine a two-engine jet trying to fly with only one engine revving.