Will Fed buy Treasuries for an extended period?

By Pedro Nicolaci da Costa

WASHINGTON (BestGrowthStock) – One hundred billion here, one hundred billion there. Pretty soon we’re talking real money.

It may not be “shock and awe” at first blush, but the ultimate sums involved in a second, widely anticipated program of Treasury bond buying from the Federal Reserve could ultimately rival the hefty first round of asset purchases.

With expectations of at least $500 billion already built into financial markets, the Fed may try to counter possible disappointment by making its commitment open ended.

It will likely do so by setting parameters vague enough to convince the markets that, like its promise to keeping interest rates low, the second round of so-called quantitative easing will be around for an “extended period” if needed.

The rationale for further monetary accommodation has been laid out by Chairman Ben Bernanke, whose views on policy carry the day at the Federal Open Market Committee.

He has made clear that, with the 9.6 percent unemployment rate far above what might be seen a normal even in a post-recession context and inflation dangling at uncomfortably low levels, policymakers deem the risk of an outright deflationary rut significant enough to justify action.

An incremental, flexible approach serves two purposes.

First, it seems commensurate with an economy that, while sluggish, is still growing, giving the Fed room to dial the pace of buying up or down depending on economic conditions.

An earlier round of unorthodox Fed easing, which totaled $1.7 trillion and centered primarily on mortgage-linked debt, was meant to quell a free fall rather than shake economic activity out of a slumber.

“Depending on evolving economic and financial conditions, QE2 has the potential to grow quite large,” said Dana Saporta, economist at Credit Suisse in New York. “The FOMC may choose to introduce forward guidance that would achieve the same effect of a ‘shock and awe’ strategy while not committing policymakers to any specific purchase total.”

The second benefit of a more cautious initial announcement would be to engender unanimity where it may be lacking. Given the untested nature of the new policy, some inflation hawks at the Fed have vocally opposed further easing in recent weeks.

CHASING SHADOWS

As for the pace of buying, two regional Fed presidents indicated this week the Fed would parcel out its buying in monthly installments of $100 billion, cementing market expectations for such a sequence.

Ever cognizant of expectations, the Fed could overshoot the market’s $500 billion base case in order to get the ball rolling and achieve the desired market effects.

For many of the Fed’s most influential members, bond purchases stimulate growth by forcing investors to buy higher yielding, riskier assets like equities and corporate bonds, driving down the cost of capital for U.S. firms.

This view might call for larger initial purchases than the market has already taken for granted, even if the game of chasing market expectations has its dangers.

“There is a potentially unstable … dynamic in which the FOMC has an incentive to go a bit farther than markets anticipate while the markets — knowing this — periodically raise the bar,” said Andrew Tilton, economist at Goldman Sachs.

While median forecasts in a Reuters poll of 27 analysts released last week pointed to $500 billion in easing, the average was closer to $650 billion. Forecasts in a separate poll of U.S. primary dealers earlier this month topped out at $1.5 trillion. (FED/R: )

SHOOTING FOR TARGETS

Another way to deflect concerns that the Fed is laying the groundwork of future inflation by further expanding credit to the banking system, already three times pre-crisis levels, is to make explicit the Fed’s presumed anchor for inflation of around 2 percent.

A numerical goal would at once boost inflation expectation s, pushing consumers and businesses to spend, but also set a tangible upward boundary for the extent of quantitative easing.

This is a boundary that could win over hawks like Charles Plosser of the Philadelphia Fed, who are skeptical about central bankers’ ability to influence any key indicators other than inflation.

Still, the Fed’s November meeting may be a bit too early to expect anything in the way of a concrete inflation goal. Discussion by some FOMC members of a bolder, price-level target that would allow the Fed to temporarily overshoot its goal suggests the issue remains very much in flux.

While Bernanke singled out 2 percent “or a bit below” as the appropriate inflation rate to shoot for, the more hawkish Jeffrey Lacker argued 1.5 percent would be better, adding that a policy statement is too fleeting a place for a benchmark meant to offer a sense of permanence and stability.

Will Fed buy Treasuries for an extended period?