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Fed Sees Both Benefits and Risks in New Moves

Binyamin Appelbaum|The New York Times
Thursday, 26 Jul 2012 | 2:56 AM ET

The argument for the Federal Reserve to introduce another round of stimulus, and its reasons for hesitation, can both be summarized by a single number: 3.53 percent, the average interest rate last week on a 30-year mortgage.

Federal Reserve Bank Chairman Ben Bernanke
Getty Images
Federal Reserve Bank Chairman Ben Bernanke

The cost of mortgages and other kinds of loans remain well above zero, a chief reason that many Fedofficials are confident the central bank still has some power to increase the pace of economic growth by continuing to reduce interest rates.

But those rates also are lower than they ever have been before, raising questions about how low they can go, and about the eventual consequences of such huge and enduring distortions to the normal workings of the financial marketplace.

Top Fed officials are coming to the conclusion that the economy is not growing fast enough to reduce the nation’s high rate of unemployment, and several members of the Fed’s policy-making committee have said additional action is needed if the economy is “stuck in the mud,” as Ben S. Bernanke, the Fed chairman, has said.

The question vexing officials as the committee prepares to meet Tuesday and Wednesday is whether the available actions would do more good than harm.

“They repeatedly say that they have additional tools to use, but they haven’t done it,” said Tim Duy, a professor of economics at the University of Oregon. “That leads one to believe that they’re not particularly confident in the tools that they have.”

The concerns are focused on the most aggressive option available to the Fed, a further expansion of its investment portfolio. They fall into two broad categories: Is the Fed disrupting markets by removing assets from circulation? And, in reducing interest rates, is the Fed pulling on a rubber band that could snap back quickly and painfully, sending those same rates soaring with disruptive consequences?

In part because of those concerns, Fed officials have said that they want to be sure of the need for additional action before they decide to make the attempt.

“I don’t think they should be launched lightly,” Mr. Bernanke said of asset purchases at a June news conference. “There should be some conviction that they’re needed.”

Mr. Bernanke controls the Fed’s decision-making process, but he is unlikely to act without the support of a significant majority of the 11 other officials who hold votes on the committee. The resolute opposition of one, Jeffrey M. Lacker, the president of the Federal Reserve Bank of Richmond, is unlikely to make a difference. But more moderate officials, including Sandra Pianalto, president of the Federal Reserve Bank of Cleveland, also have stopped short of clear support for new actions in recent speeches, citing uncertainty about the economy and concern about the costs.

Some Wall Street analysts have concluded that the Fed is unlikely to act before its September meeting, once it has seen data on job creation in July and August.

The Fed already is engaged in a huge campaign to reduce borrowing costs for businesses and consumers. It has held short-term interest rates near zero since late 2008, and it has said that it expects to maintain that policy at least until late 2014. To put further pressure on long-term rates, it has acquired almost $3 trillion of mortgage-backed securities and longer-term Treasury securities — an effort that it has already said will continue until the end of this year.

The purchases drive down interest rates by reducing the supply of assets like long-term Treasury securities. Scarcity raises prices, meaning that investors are accepting a lower rate of return. It also pushes some investors to move their money into other assets, with much the same effect of lowering rates.

The policies, along with a weak economy that has reduced demand for loans, have helped to push a wide range of borrowing costs to the lowest levels on record.

In addition to the low level of mortgage rates, investors effectively are paying the federal government for the privilege of financing the national debt.

Borrowing costs for companies with good credit fell to an average of 3.04 percent Wednesday, the lowest level on record, according to an index compiled by Bank of America Merrill Lynch. Rates have dropped 22 percent this year.

The Fed’s efforts also have pumped up the stock market and held down the cost of American exports by pushing down the value of the dollar.

The extent of economic benefits from these lower rates remains a subject of considerable debate, but the basic mechanics are clear enough.

Lower mortgage rates, for example, encourage people to buy homes, allow them to afford more expensive homes and let existing homeowners refinance. The benefits do not directly reach homeowners who are underwater or borrowers who cannot qualify for loans. But the Obama administration estimatesthat refinancing alone has saved homeowners some $27.7 billion over the last three years.

Companies also have taken advantage. The industrial conglomerate United Technologies in May staged the largest bond sale since the recession, raising $9.8 billion to finance its purchase of the aerospace firm Goodrich. The brewer Anheuser-Busch InBev raised $7.5 billion in mid-July toward its purchase of Grupo Modelo.

But corporate bonds also highlight the difficulties confronting the Fed.

The increase in total borrowing has been modest. Issuance of domestic corporate bonds increased by 2 percent in the first half of 2012, as compared with the first six months of 2011, according to data compiled by Bloomberg.

The Fed’s ability to reduce the cost of government debt has only partly translated to the private sector. Rates on corporate debt have fallen much more slowly than on Treasuries, more than doubling the difference between corporate and government interest rates before the recession.

Mortgage rates remain similarly elevated in comparison to Treasuries, although some Fed officials say they believe this could be addressed by purchasing mortgage securities. The Fed is forbidden by law from purchasing corporate debt.

The disappointing reduction in rates, and the muted response to those lower rates, may be seen as a reason for the Fed to increase the scale of its efforts.

But some economists are concerned about the possibility that additional purchases will impede the use of Treasuries as a kind of global currency.

“By reducing the supply of Treasury bonds, the economy is deprived of extremely safe and liquid assets,” the Northwestern University economists Arvind Krishnamurthy and Annette Vissing-Jorgensen wrote Tuesday. They suggested that the Fed should buy mortgage securities with money raised by selling Treasuries.

The Fed also does not want to own such a large share of Treasuries that the volume of buying and selling becomes too small to produce reliable prices.

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