The Fed’s goal would be to keep downward pressure on long-term interest rates and encourage individuals and companies to borrow and spend. If it succeeds, the Fed might at least soften the blow from tax increases and spending cuts that will kick in in January if Congress can’t reach a budget deal.
But its actions wouldn’t rescue the economy. Chairman Ben Bernanke warned last month that if the economy fell off a “broad fiscal cliff,” the Fed probably couldn’t offset the shock.
Fears of the cliff have led some U.S. companies to delay expanding, investing and hiring. Manufacturing has slumped. Consumers have cut back on spending. Unemployment remains a still-high 7.7 percent. If higher taxes and government spending cuts lasted for much of 2013, most experts say the economy would sink into another recession.
On Tuesday, the Fed began a two-day meeting, which will end Wednesday afternoon with a statement announcing its policy decisions. Afterward, the Fed will update its forecasts for the economy, and Bernanke will hold a news conference.
The expectation is that the Fed will unveil a program to buy $45 billion a month in long-term Treasurys. This would replace an expiring program called Operation Twist. With Twist, the Fed sold $45 billion a month in short-term Treasurys and used the proceeds to buy the same amount in longer-term Treasurys.
Twist didn’t expand the Fed’s investment portfolio; it just reshuffled the holdings. But the Fed has run out of short-term securities to sell. So to maintain its pace of long-term Treasury purchases and help keep long-term rates low, it must spend more and increase its portfolio.
The new bond purchase plan would join a program announced in September.
Under that program, the Fed is buying $40 billion a month in mortgage bonds to try to force already record-low home-loan rates lower to encourage home buying. The total Fed bond purchases from the two programs would remain $85 billion.
“The Fed really has only one key decision at the meeting, and that is how much of the current program will they replace,” said David Jones, the chief economist at DMJ Advisors.
If, on the other hand, the Fed chooses not to replace Twist with a new bond-buying program, the value of its long-term Treasury purchases will decline by half. Long-term borrowing rates might rise as a result.
When the Fed pumps more money into the financial system and adds to its portfolio, it’s called quantitative easing. Critics argue that quantitative easing risks escalating inflation later. The Fed’s portfolio totals nearly $2.9 trillion — more than three times its size before the 2008 financial crisis.
The Fed has launched three rounds of quantitative easing since the financial crisis hit. In announcing QE3 in September, the Fed said it would keep buying mortgage bonds until the job market improved substantially. It also extended its plan to keep its benchmark short-term rate near zero through at least mid-2015. And it raised the possibility of taking other steps.
Skeptics note that rates on mortgages and many other loans are already at or near all-time lows. So any further declines in rates engineered by the Fed might offer little economic benefit.
But besides seeking to spur lending, the Fed’s drive to cut rates has another goal: to induce investors to shift money out of low-yielding bonds and into stocks, which could lift stock prices. Stock gains boost wealth and typically lead individuals and businesses to spend and invest more. The economy would benefit.
Inside and outside the Fed, a debate has raged over whether the Fed’s actions have helped support the economy over the past four years, whether they will ignite inflation later and whether they should be extended. At this week’s meeting, some regional Fed bank presidents will likely express concern that more bond buying will further flood the financial system with money and eventually send prices soaring.
One such critic, Jeffrey Lacker, the president of the Federal Reserve Bank of Richmond, has cast a lone dissenting vote at all seven Fed policy meetings this year. Lacker has said he thinks the job market is being slowed by factors beyond the Fed’s control. And he says further bond purchases risk worsening future inflation.
Others, like John Williams, the president of the San Francisco Fed, have said they think the Fed’s bond purchases must continue because the job market and other components of the economy are improving only gradually.
The Fed is also expected this week to resume discussions on how to signal future policy moves to the public more clearly. Since August 2011, the Fed has identified a target date to try to reassure markets that it doesn’t plan to raise short-term rates soon.
Some Fed officials, however, oppose using a target period to signal the earliest when it might start raising rates. They’ve been urging that future interest-rate moves be linked to how the economy is faring as measured by unemployment and inflation.
Chicago Fed President Charles Evans, a proponent of this change, would set the unemployment target at 6.5 percent and the inflation target at 2.5 percent. If those targets were adopted, the Fed would say it didn’t plan to raise rates until unemployment drops below 6.5 percent – as long as the Fed’s inflation gauge is no more than 2.5 percent. The Fed’s inflation measure over the past 12 months has risen just 1.7 percent, signaling that inflation pressures are well-contained.
Many private economists expect no change in the Fed’s communications strategy this week. They think officials are far from a consensus on how to adopt numerical targets for any interest-rate move. But a change could come next year.
By contrast, there’s widespread expectation that the Fed will announce a program to replace Operation Twist. If it didn’t, the Fed’s support for the economy would be reduced at a time when growth is weak and unemployment still high.
“They can’t have the current level of bond buying come to an end with all the uncertainty of the fiscal cliff just around the corner,” said Greg McBride, the senior financial analyst at Bankrate.com.
The Fed’s meeting coincides with negotiations between Congress and President Obama over a budget deal to avert the fiscal cliff. The talks are focused on Obama’s push to raise tax rates for the top 2 percent of income earners. Most Republicans are resisting such a move.
Brian Bethune, an economics professor at Gordon College, says he thinks Fed officials this week might discuss what further action they could take if Congress and the administration fail to reach a deal before January and the tax increases and spending cuts take effect.
“We are in unusual times, and that may require an unusual amount of Fed policy actions,” Bethune said.