Fed to pump nearly $1.2 trillion into the financial system

The Federal Reserve made it clear Wednesday that it will do whatever it takes to end the worst U.S. downturn since the Great Depression, announcing new plans to pump nearly $1.2 trillion into the financial system, including a historic commitment to buy up to $300 billion in longer-term Treasury securities.

As part of its unexpectedly aggressive plan, the Fed also committed to hold a key interest rate essentially at zero "for an extended period" and to buy up to another $850 billion in mortgage-backed securities and debt. The actions could quickly translate into lower borrowing costs for home buyers, homeowners and businesses — and that, in turn, could help get the stalled economy moving again.

The Dow Jones industrial average surged 91 points, to 7487, on news of the Fed's actions. Interest rates on Treasuries plummeted, with 10-year notes posting the biggest one-day move in nearly 50 years. The U.S. dollar sank against other currencies, however, as traders worried about the long-term implications of the policies, including possible inflation.

Nevertheless, most experts applauded the Fed. "When you have a forest fire, gradualism is not a good idea," said Richard Hoey, chief economist at Dreyfus. "The aggressiveness of the Fed's action is consistent with the view that they understand the risks and have the power to act. This is not Hamlet deciding what to do."

The Fed said the dire economic outlook prompted its moves. U.S. unemployment is at a decades-high rate of 8.1%, with businesses shedding about 650,000 jobs a month. The economy shrank at a 6.2% annual rate in the final three months of 2008, and economists expect nearly as bleak a number for the first quarter of 2009. Inflation has fallen as the economy has slowed, to the point that the Fed openly worries about the possibility of deflation — a widespread sustained fall in prices that could prolong the downturn.

"Although the near-term economic outlook is weak, the (Fed) anticipates that policy actions … will contribute to a gradual resumption of stable economic growth," the Fed said.

Fed actions

What the Fed will do:

•Buy up to $300 billion in longer-term Treasury securities during the next six months. The move, which follows similar efforts in Britain and Japan, is designed to bring down longer-term interest rates that influence business and consumer borrowing.

•Buy up to another $750 billion in mortgage-backed securities issued by mortgage-finance giants Fannie Mae and Freddie Mac, which are in government conservatorship. The Fed has already committed to buy $500 billion in mortgage-backed securities, bringing planned purchases to $1.25 trillion. The Fed will also double the amount of Fannie and Freddie debt it plans to buy to $200 billion. The move is significant, given that Fannie and Freddie now back about 70% of home mortgages made in this country. About $1.4 trillion in mortgages were issued last year.

•Possibly expand the range of collateral the Fed will accept under a recently launched program to spur student loan, auto, credit card, small business, commercial real estate and other lending. The Fed and Treasury Department have said that they hope to eventually spur up to $1 trillion in lending under the so-called Term Asset-Backed Loan Facility.

The Fed's medicine worked almost immediately. The 10-year Treasury bond yield dropped 0.51 of a percentage point, to 2.50%, a plunge that left money managers stunned. "It's the biggest one-day move in my career, and I started in 1978," says Bob Auwaerter, bond manager at the Vanguard Group. The bellwether note's yield fell the most since 1962, according to Bloomberg News.

That could prompt what analysts expect will be the biggest consumer impact from the Fed's actions: lower mortgage rates, says Greg McBride, senior financial analyst for Bankrate.com. "Today's announcement is good news for refinancing," McBride says. Since the Fed said it will be buying Treasuries all year, "It assures an environment of low mortgage rates through the end of the year."

McBride expects mortgage rates to drop about as much as the yield on the bellwether 10-year Treasury note did Wednesday — in other words, about half a percentage point. The average 30-year fixed mortgage rate tracked by mortgage giant Freddie Mac was 5.03% last week. Wednesday's Fed actions would drop rates to about 4.5%.

In the past year or so, mortgage rates haven't necessarily moved down in lockstep with the 10-year T-note, in part because lenders haven't been willing to make as many new loans as before. The Fed's decision to buy $750 billion of mortgage-backed securities will help make sure that there is plenty of mortgage money available. Banks will be able to package their mortgage loans, sell them in the securities markets with Fannie and Freddie backing, and use the proceeds to replenish their lending coffers. At the same time, the Fed's purchases of mortgage-backed securities will push mortgage yields down, too.

The Fed is taking a two-pronged approach, says Hoey. "Buying Treasuries pulls down yields, and the purchase of mortgage-backed securities pulls down the spreads."

The aim is to push down mortgage rates as far as the yields on Treasuries.

Credit card customers and other borrowers won't get much relief. Those rates are tied to the prime lending rate, which, in turn, is tied to the key fed funds rate. The prime is 3.5%, but the fed funds rate is between zero and 0.25% — which means there's no room to go lower. "They can't cut short-term rates," McBride says.

On the other hand, savers won't see their rates fall much either, mainly because they can't go much lower. The average money market mutual fund yields 0.25%, according to iMoneyNet, which follows the funds. The average one-year bank CD yields 2.07%, says Bankrate.com.

Overall economy

The Fed's announcement on Wednesday is just one in a series of increasingly aggressive efforts to aid the economy. The Fed's balance sheet, an accounting of its assets and obligations, has already ballooned from $800 billion last year to about $2 trillion today as it has rolled out a series of programs to lend to banks and other firms. Further, the latest announcements come on top of recently announced programs, such as the asset-lending facility, that are not yet reflected on the Fed ledger.

The Fed actions are also a striking demonstration of the fact that even though it has cut interest rates essentially to zero, it is not yet out of tools to try to revive the economy.

Some analysts cautioned that even while the Fed's decision to essentially print another $1 trillion may be necessary in the short run, it also carries some major risks.

"It is like a cancer patient that is given a heavy dose of chemo and radioactive therapy to cure their cancer, but the patient first appears to get sicker with each passing day," says Scott Anderson of Wells Fargo. "Renewed dollar weakness is likely. Longer-term, the U.S. economy could face higher inflation and higher interest rates."

Are the Fed's moves ultimately inflationary? "Yes, but the key word is ultimately — not weeks or quarters, but a couple of years down the road. I'm not at all worried about it today," says Joe Balestrino, portfolio manager for Federated Investors. The real worry, Balestrino says, is deflation — a prolonged period of declining prices. The Fed cited deflation concerns Wednesday.

The Fed appears to be trying to get out ahead of the troubled financial market — and an increasingly fractured political process. As the Fed's policymaking Open Market Committee was meeting Wednesday, lawmakers on Capitol Hill were grilling American International Group CEO Edward Liddy about bonuses paid to employees of the firm. The political furor is intensifying what Fed Chairman Ben Bernanke told CBS' 60 Minutes Sunday was the biggest economic risk — that the U.S. lacks the political will to stabilize the financial industry.

"The Fed is not really circumventing the political process, but it's definitely using its authority to try to get the financial system in recovery mode and the economy back on its feet," says Kim Rupert of Action Economics.

Bernanke and his colleagues on the Open Market Committee voted unanimously Wednesday for the series of policies to pump money into the broad economy, reduce interest rates and bolster markets for specific financial products. The Treasury Department is expected to announce more detailed plans for a private/public effort to pull toxic assets off banks' balance sheets so they can step up lending.

So far, many key policy decisions have been dependent on the Fed's willingness to aggressively expand lending and asset purchase programs.

"It's a Rambo Fed," says Hoey. "They are fighting a serious economic recession and are willing to act aggressively."