The trouble with the Fed’s secret bailout

The Federal Reserve has come clean about its covert actions. Now it's time to look at the worrisome consequences

By Robert Reich

The Federal Reserve building is shown in Washington

The U.S. Federal Reserve Building is pictured in Washington, January 26, 2010. The U.S. Federal Reserve's Federal Open Market Committee began its two-day rate-setting meeting Tuesday, and while no change in interest rate conditions is expected, there is still plenty for investors to watch and worry about as the Senate debates Chairman Ben Bernanke's nomination for a second term as Fed chairman. REUTERS/Jason Reed (UNITED STATES - Tags: BUSINESS) (Credit: Â© Jason Reed / Reuters)

Topics:Federal Reserve, Bank Reform

The Federal Reserve has finally came clean. It now admits it bailed out Bear Stearns — taking on tens of billions of dollars of the bank’s bad loans — in order to smooth Bear Stearns’ takeover by JPMorgan Chase. The secret Fed bailout came months before Congress authorized the government to spend up to $700 billion of taxpayer dollars bailing out the banks, even months before Lehman Brothers collapsed. The Fed also took on billions of dollars worth of AIG securities, also before the official government-sanctioned bailout.

The losses from those deals still total tens of billions, and taxpayers are ultimately on the hook. But the public never knew. There was no congressional oversight. It was all done behind closed doors. And the New York Fed — then run by Tim Geithner — was very much in the center of the action.

This raises three issues.

First, only Congress is supposed to risk taxpayer dollars. The Fed is not part of the legislative branch. Its secret deals, announced almost two years after they were done, violate the democratic process, if not the Constitution itself. Thomas Jefferson put a stop to Alexander Hamilton’s idea of a powerful central bank out of fear it would be unaccountable to the public. The Fed has just proven Jefferson’s point.

Second, if the Fed can secretly bail out big banks, the problem of “moral hazard” — bankers taking irresponsible risks because they know they’ll be rescued — is far greater than anyone assumed after Congress and the Bush and Obama administrations bailed out the banks. Big banks will always be too big to fail because they know the Fed will secretly back them up if they get into trouble, even if Congress won’t do it openly.

Third, the announcement throws a monkey wrench into the financial reform bill now on Capitol Hill, which gives the Fed additional authority by, for example, creating a consumer protection bureau inside it. Only yesterday, Sen. Jim DeMint, R-S.C., blasted the Dodd bill for expanding the Fed’s authority “even as it remains shrouded in secrecy.”

The Fed has a big problem. It acts in secret. That makes it an odd duck in a democracy. As long as it’s merely setting interest rates, its secrecy and political independence can be justified. But once it departs from that role and begins putting billions of dollars of taxpayer money at risk — choosing winners and losers in the capitalist system — its legitimacy is questionable.

That it chose to reveal the truth about its activities during a week when Congress is out of town, when much of official Washington and the Washington media have gone on vacation, and only after several federal courts have held that the Fed must release documents related to its bailout of Bear Stearns, suggests it would rather remain secret than become transparent.

Much of what Ben Bernanke and Tim Geithner did (when Geithner was at the New York Fed) in 2008 was presumably necessary. But the public has no way of knowing. The public doesn’t even know who else the Fed has bailed out, or what entities it will bail out in the future. All we know is the Fed secretly bailed out Bear Stearns and AIG and thereby subjected taxpayers to risks that remain even today, without informing the public. That’s not a record on which to build public trust.

: Robert Reich, a professor of public policy at the University of California at Berkeley, was secretary of labor during the Clinton administration. He is also a blogger and the author of "Aftershock: The Next Economy and America's Future." More Robert Reich

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Ron Paul’s wacky but influential Fed policy

Despite his crackpot theories about the central bank, his Republican rivals often echo his ideas

By Gary Weiss

Republican presidential candidate Rep. Ron Paul (Credit: AP)

Topics:War Room, Ron Paul, Federal Reserve

The Republican Party, falling deeper into the clutches of Ron Paul’s radical ideology, has a new item on its anti-populist agenda: Castrate the Federal Reserve so that it no longer can promote job growth.

In Fed-speak, this is known as cutting in half the Fed’s “dual mandate” to curb inflation and unemployment, by taking out the “unemployment” part — the nation’s persistently high jobless rates notwithstanding. The ranking Republican on the Joint Economic Committee, Kevin Brady, disclosed this week that he is drafting legislation that would turn the Fed’s long-standing “dual mandate” into a single mandate.

This great leap backward isn’t likely to happen as Democrats remain in control of the Senate. But what it does show is the extent to which Ron Paul’s fixation with the Fed has infected the Republican Party. Anti-Fed rhetoric, once the province of ultra-right groups like the John Birch Society, has gone mainstream with the rise of Paul, who has been surging in the polls and now ranks third behind Mitt Romney and Newt Gingrich. He is actually leading in Iowa, and a victory there would really rev up his famously loyal followers.

It’s no secret that Paul wants to end the Fed. That’s the title of one of his books, and it’s central to his libertarian ideology, which is influenced by Ayn Rand, who opposed the Fed’s existence, and Austrian economists who championed laissez-faire. In January 2011 he became head of the House Financial Services subcommittee overseeing domestic monetary policy. Given Paul’s growing influence, it’s not surprising that Republicans are pushing for a measure that would cut back significantly on the Fed’s power. Bray’s legislation amounts to “Ron Paul Lite.” The proposed law wouldn’t toss the Fed in the ashcan, as Paul wants, but it would go to the very heart of the Fed’s mission.

The dual mandate has been around since 1977, when the Federal Reserve Act was amended to require the Fed to strive to curb both unemployment and inflation. The operative language in the Federal Reserve Act, in its Section 2a, is as follows: “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregrates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

What this means is that the Fed can’t just focus on inflation, but must take into consideration whether its policies will help or impede the functioning of the economy as a whole. Fed Chairman Ben Bernanke made that point in a speech to the CATO Institute in 2007. In other words, the dual mandate is just common sense. It’s not terribly controversial, either, unless you’re really indifferent to throwing people out of work.

Now, it has to be understood that Paul is not in favor of paring the dual mandate. As he pointed out when the idea surfaced in 2010, he thinks that’s a wimpy half-measure and “grandstanding.” The libertarian serial presidential candidate and faux populist doesn’t want the Fed to have any mandate — or power — at all.

Some of the elements in Brady’s legislation, as it has been leaked to the press, are worthwhile. His bill would provide greater transparency for the Fed. The minutes of Fed meetings, now disclosed within three weeks, would be released in 15 days. Fed purists don’t like it, but it’s hard to see the harm in that. The bill would also open up the membership of the Fed’s Open Market Committee, which sets monetary policy, to representatives of all 12 regional Fed banks. Now the positions are primarily controlled by the president. That could actually backfire on the Republicans, because some of those regional bank presidents might want to keep the Fed focused on job creation, even if it’s ostensibly stripped of its ability to do so. If that part of the law is passed without the dual mandate, it might actually be a good thing.

The Fed needs more sunshine, especially when it comes to its actions during the 2008 financial crisis. The Fed has shamefully fought disclosing the details, which media organizations, especially Bloomberg, have been fighting. The January issue of Bloomberg Markets broke the story of $13 billion in undisclosed Fed loans that were doled out to the banks.

But there’s a distinction between agitating to open the Fed to public view, or even throwing a bone to the right by “auditing” it, and getting rid of it entirely. With Paul ascendant, Fed-bashing is going to happen a lot in the months ahead, and it’s important to distinguish informed criticism from ideologically driven rhetoric.

Paul is a master of the latter. Here’s Paul on the Fed’s role in the financial crisis: “The Federal Reserve is the chief culprit behind the economic crisis. Its unchecked power to create endless amounts of money out of thin air brought us the boom and bust cycle and causes one financial bubble after another.” [Emphasis in the original] He goes on to point out that the dollar lost 93 percent of its value since the Federal Reserve was created in 1913.

What Paul ignores is that there were booms and busts and inflation long before there ever was a Federal Reserve. His claims dovetail with the right-wing counter-narrative of the financial crisis, which diverts attention from abuses by too-big-to-fail banks by focusing on government policies. But Paul goes further by retailing the conspiracist humbug that the Fed may have funded the Watergate burglars and Saddam Hussein’s nuclear program. Paul even pressed for an audit of the gold at Fort Knox, apparently to make sure that James Bond’s nemesis, Auric Goldfinger, could not make off with the stocks.

A lot of this is symbolic posturing, as is usual where the Fed is concerned. The right has long been uncomfortable with the dual mandate. George F. Will, in a column back in 2010, contended that the dual mandate turns the Fed into the “fourth branch of government,” and cited criticism of the Fed’s job-boosting powers from Paul Ryan, now chairman of the House Budget Committee. Ryan was quoted as pushing the Ron Paul nostrum that what the Bureau of Engraving and Printing churns out is really “fiat money,” since it’s not backed by gold. Paul believes in a return to the gold standard, an idea that has been dismissed by economists for decades as guaranteeing a slide into another Great Depression.

Paul’s influence is metastasizing to the rest of the GOP field, who are falling over themselves to show that they’ll get tough with the Fed. Newt Gingrich has made attacks on the Fed part of his repertoire, suggesting that the Fed should be stripped of its banking powers and — taking aim at the dual mandate — focus entirely on strengthening the dollar. Rick Santorum also supports wiping out the dual mandate, and Michele Bachmann has made Paul-like noises, joining in the populist-sounding calls to audit the Fed — a symbolically powerful but otherwise meaningless idea that is one of Paul’s longtime talking points. (Gingrich is another “audit the Fed” fan.) Bachmann said in one debate that the Fed needs to be “shrunk back down to such a tight leash that they’re going to squeak.”

The only holdout is Mitt Romney. This is one of the few issues about which he hasn’t flip-flopped — yet. He has generally avoided the subject, which has drawn fire from Fed critics.. But all of the GOP hopefuls, including Romney, would get rid of Bush appointee Ben Bernanke, ostensibly because he has promoted inflation but most of that is the lingering odor of the bailouts — not a terrible reason to eject the guy. Or at least it would be, if he served at the pleasure of the president, which he doesn’t. His term as chairman expires in early 2014. Assuming he’d leave if asked to do so, his replacement in a GOP administration would probably be in the mold of Alan Greenspan, a fiscal conservative and inflation-buster who did his darndest to subvert financial regulation whenever possible.

What we can say for sure is that a Republican victory in 2012 would probably spell the end of the dual mandate, in fact if not by law, reducing or eliminating the Fed’s role in reviving the job market. A Great Depression wouldn’t arrive immediately, as it would if the gold standard were revived as Paul wants. But if true economic calamity threatens, you can bet that a GOP-controlled Fed won’t do a thing to stop it from coming.

: Gary Weiss is a journalist and the author of "Ayn Rand Nation: The Hidden Struggle for America's Soul," to be published by St. Martin's Press on February 28, 2012. Follow him on Twitter @gary_weiss. More Gary Weiss

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Should the Fed save Europe?

A top think tank wants America's central bank to act as the EU's lender of last resort. Its director explains why

By David Case, GlobalPost

The Federal Reserve Building in Washington, D.C. (Credit: Wikipedia)

Topics:GlobalPost, European Financial Crisis, European Union, Federal Reserve

This article originally appeared on GlobalPost.

BOSTON — Europe’s inability to devise a strategy for solving its debt crisis has become a dire threat.

Economists say it could throw the world back into the kind of crisis that reached its nadir in 2008 and 2009, destroying trillions of dollars in wealth and causing millions to lose their jobs.

In the euro zone mess, so far the U.S. has largely played the role of an outsider, reiterating the urgency of dealing with the mess. On Tuesday, for example, the U.S. Federal Reserve’s second-in-command Janet Yellen urged European leaders to take “forceful action.”

But now a respected Washington economic policy shop is saying that Yellen’s bank itself should get involved directly. The Center for Economic Policy and Research (CEPR) is calling on America’s central bank to become a lender of last resort for the heavily indebted nations, to reduce their interest rates from unsustainable levels — Italy, Europe’s third largest economy is paying over 7 percent for its debt, a level at which other countries have required bailouts.

France, among others, has urged the European Central Bank to play this role. But Germany — which effectively has veto power — has resisted, fearful of inflation and of harm to its economy.

So why should the U.S. get involved? And what would it cost? GlobalPost spoke with CEPR Co-Director Mark Weisbrot to learn more.

Having accurately predicted, in 2002, that a housing bubble would cause a financial meltdown, CEPR is a key alternative voice on economics, and a widely-quoted resource for journalists. (The interview has been edited by GlobalPost.)

GlobalPost: You’ve called for the U.S. Fed to act as a lender of last resort for debt-laden European nations, such as Italy and Spain, to prevent them from having to pay unsustainable interest rates on their debt. Why interfere with the free market, and why is this the United States’ business when we have our own financial problems to deal with?

Mark Weisbrot: The problem is that Europe’s financial crisis is already slowing the global economy. The OECD just lowered its growth projection for the U.S. economy from 3 to 2.1 percent for next year, and estimated that the euro zone is already in recession.

The OECD’s projections assume that there won’t be a major crisis in the banking system. Such a crisis gets increasingly likely each week that the European authorities fail to act. So this is the U.S.’ financial problem. If Europe has a systemic problem of the type that happened after the collapse of Lehman Brothers in 2008, or worse, the US economy could get pushed into recession.

How much would this cost, and what would the impact be on U.S. taxpayers and the American economy?

There would not be any cost to the taxpayers, since the Fed could carry out this program just as it has done its $2.3 trillion of quantitative easing (QE) since 2008, by creating money.

If the Fed would be printing money to buy Europe’s sovereign debt, wouldn’t that cause inflation?

The Fed’s QE program since 2008 did not have any measurable effect on inflation, so there is no reason to expect that these purchases would either. The OECD projects inflation for next year to be 1.6 percent for the euro area and 1.9 percent in the U.S. So even if inflation did rise some, it would not hurt. In fact, a higher level of inflation in current circumstances would probably lead to greater economic activity and higher employment.

Has the Fed ever tried anything like this before? Was it successful? And how is it in the Fed’s mandate to intervene outside US borders?

The Fed has a mandate to promote full employment within the United States. Avoiding a recession caused by a financial crisis in Europe certainly falls within this mandate.

To my knowledge the Fed hasn’t done this before, but it has coordinated with other central banks, for example in 2008, to provide liquidity to the banking system in Europe during the financial crisis.

The Chinese successfully pushed U.S. long-term interest rates down from 2004-2006 by buying long-term U.S. treasury bonds, so we know that this type of foreign purchase can work. The Chinese had to accumulate dollar-denominated assets, in order to maintain their fixed exchange rate. But by buying long-term (instead of short-term) treasuries they succeeded in keeping these U.S. rates low, thereby boosting US growth and stimulating demand for their own exports.

This situation is much more urgent for the US since we are facing the threat of a major financial crisis, and possibly deep recession in Europe, that could push the US economy into recession.

Why not let the IMF be the lender of last resort for Europe? Isn’t rescuing the debt-laden what the IMF specializes in?

This could happen, but it may not; and if it were to happen, the IMF “rescue” would almost certainly include austerity policies as conditions for the loans. That could drive Europe further into recession and thereby be self-defeating — as has happened in Greece and Portugal, and is now happening in Italy.

Doesn’t using the Fed in this way set a dangerous precedent — that governments can live beyond their means and then they’ll simply be bailed out if they are too big to fail? Shouldn’t the profligate countries pay for their sins?

The “debt crisis” of Europe was not caused by profligacy, but by the collapse of bubble-driven growth and the resulting financial crisis — most prominently in the U.S. but also in the euro zone. Prior to this collapse, these countries had mostly reduced their debt burdens, with the exception of Greece. And even the Greek debt problem of two years ago was manageable with minimal intervention from the European authorities.

So this is not really a debt crisis at all, nor a crisis caused by governments over-borrowing. It is a crisis of policy failure. The whole mess has been caused by the failure of the European authorities to engage in the proper monetary and fiscal policies to restore growth; in fact their forced austerity has made it much worse.

Why use this power for Europe and not for Zimbabwe or Japan or other heavily-indebted countries?

Japan can take care of itself, and doesn’t really have a debt problem anyway. Its net interest payments on the debt – which are what matters, not the gross debt/GDP ratio — are still under 2 percent of GDP. As for other countries, the Fed is not responsible for them. The main reason for intervening in Europe is that the European authorities are threatening to push the US economy into recession.

: David Case is a senior writer and editor at GlobalPost. Follow him @DavidCaseReport. More David Case

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Fed foresees far weaker growth than it had earlier

Prospects gloomy for driving down unemployment

By Martin Crutsinger, Associated Press

Federal Reserve Board Chairman Ben Bernanke testifies on Capitol Hill in Washington, Tuesday, Oct. 4, 2011, before the Joint Economic Committee hearing on the economic outlook. (Credit: AP/Evan Vucci)

Topics:Federal Reserve, U.S. Economy, Unemployment

WASHINGTON (AP) — The Federal Reserve sketched a bleaker outlook Wednesday for the economy, which it thinks will grow much more slowly and face higher unemployment than it had estimated in June.

The Fed now predicts the economy will grow at a scant 1.6 percent to 1.7 percent for 2011. For 2012, it thinks growth will range between 2.5 percent and 2.9 percent. Both forecasts are roughly a full percentage point lower than its June forecast.

The Fed sees unemployment of between 8.5 percent and 8.7 percent next year. In June, it had predicted unemployment would drop next year to as low as 7.8 percent. The rate is now 9.1 percent.

The Fed’s gloomier outlook is similar to many private economists’ forecasts. Bank of America Merrill Lynch, for example, expects only 1.8 percent economic growth this year and 2.1 percent in 2012.

Those growth rates are far too low to drive down unemployment.

Even so, the Fed said after its policy meeting that the economy had improved since nearly stalling in the spring. As a result, it’s putting off any new actions so it can gauge the impact of steps it’s already taken.

Fed policymakers made the announcement after a two-day meeting.

In a statement, the officials said consumers have stepped up spending. Still, they said the economy continues to face significant risks, including the debt crisis and risk of recession in Europe.

The Fed left open the possibility of taking further steps later to try to boost the sluggish economy. But it gave no hint as to what those moves might be.

“They’re noting the better growth numbers but remain pretty cautious,” said Michael Feroli, a former Fed economist now with JPMorgan Chase & Co. “They’re not celebrating by any means, which probably is appropriate.”

The vote was 9-1. Charles Evans, the president of the Chicago Federal Reserve Bank, dissented. The statement said Evans wanted to take stronger action to try to boost the economy.

The vote was a shift from the previous two Fed meetings, when three members had dissented for the opposite reason: They opposed the Fed’s continued efforts to keep rates at super-lows, for fear it could ignite inflation. Those three members, known as inflation “hawks,” dropped their opposition this time.

Some analysts said the shift didn’t necessarily mean the Fed is any likelier to take any additional action soon to try to boost the economy.

“The view of the hawks is that once the decision has been made by the majority, it just causes confusion if they continue to vote to roll back action that has already been taken,” said Paul Ashworth, chief U.S. economist at Capital Economics.

Some analysts said they expected the Fed to take further action to support the economy at coming meetings, given their expectation that growth will remain sub-par.

“Policymakers are keeping the door open because the unemployment rate remains high, and there are clear downside risks from the economic situation in Europe,” said Sal Guatieri, senior economist at BMO Capital Markets.

After their September meeting, the policymakers said they would shuffle the Fed’s investment portfolio to try to further reduce long-term interest rates. And in their previous meeting in August, they had said they plan to keep short-term rates near zero until at least mid-2013, unless the economy improved.

The Fed repeated the mid-2013 target in its statement Wednesday. It also said it was continuing its program to rebalance its portfolio to try to lower long-term rates.

The Fed has kept its key short-term interest rate at a record low since December 2008. This is the rate that banks charge on overnight loans. It serves as the benchmark for millions of business and consumer loans.

Later Wednesday, the Fed will also release its economic forecasts, and Chairman Ben Bernanke will hold a news conference.

The Fed noted that growth strengthened over the summer, in part because temporary factors that had weighed on the economy in the spring had eased. Consumers are able to spend a little more because gas prices have declined from their May peak of roughly $4 a gallon. And auto sales and production have picked up now that supply chains disrupted by the March earthquake in Japan are flowing more freely.

But the Fed said the job market remains weak. And it suggested that the troubles in Europe could hurt U.S. growth.

The debt crisis in Europe could force the Fed to lower its economic projections. The Greek prime minister’s surprise move to call a referendum on the country’s latest rescue plan sparked fears that the debt deal could unravel, that Greece could default on its debt and that the crisis could infect the global financial system.

Even if Europe dodges a financial catastrophe, many economists think it’s headed for a recession that would affect the U.S. and global economies. The Fed expressed such concerns after its August meeting.

Still, the Fed remains deeply divided over what, if any, action to take next.

The actions taken in August and September were adopted on 7-3 votes, the most dissents in nearly 20 years.

Three regional bank presidents — Richard Fisher of Dallas, Charles Plosser of Philadelphia and Narayana Kocherlakota of Minneapolis — all voted no. They have expressed concerns that the Fed’s policies could lead to high inflation later.

On the other hand, Vice Chair Janet Yellen, Governor Daniel Tarullo, Evans and New York Fed President William Dudley have said the economy is at risk and might need more support.

Two officials pushed for bolder action at the September meeting, according to minutes. The members discussed more bond-buying. Some said it should remain an option.

A brighter outlook for the economy has given the Fed more room to wait. The economy grew at an annual rate of 2.5 percent in the July-September period — the best quarterly performance in a year. That was largely because consumers increased their spending at triple the rate from the previous quarter.

The growth is strong enough to show that the economy isn’t about to slide into recession. Still, growth would have to be nearly twice as high — consistently — to make a major dent in the unemployment rate, which has been stuck at 9.1 percent for three straight months.

Evans has proposed that the Fed set benchmarks for raising rates. For example, it could agree not to raise short-term rates until unemployment fell below 7 percent or the outlook for inflation exceeded 3 percent. The unemployment rate has hovered around 9 percent for more than two years, and the Fed’s inflation outlook is under 2 percent.

___

AP Economics Writers Christopher S. Rugaber and Daniel Wagner contributed to this report.

: More Martin Crutsinger

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Operation treason?

Why markets are tanking: The Fed's new plan admits the economy is in trouble but doesn't come close to fixing it

By Andrew Leonard

U.S. Federal Reserve Chairman Ben Bernanke testifies before the Senate Banking, Housing and Urban Affairs Committee hearing on Enhanced Oversight After the Financial Crisis: The Wall Street Reform Act at One Year on Capitol Hill in Washington, July 21, 2011. REUTERS/Yuri Gripas (UNITED STATES - Tags: POLITICS BUSINESS HEADSHOT) (Credit: Â© Yuri Gripas / Reuters)

Topics:Ben Bernanke, Federal Reserve, How the World Works

If the stock market reaction is any indicator, the early reviews of Ben Bernanke’s latest scheme to juice the economy, “Operation Twist,” are negative. At 1 p.m. ET, the Dow Jones industrial average was down nearly 360 points.

Deciphering investor psychology is never straightforward, and particularly so recently, when there are so many potential reasons for fear and panic: our amazingly dysfunctional U.S. Congress, the ongoing European drama, and the steady drumbeat of negative economic indicators. But today’s tremors can be tied to the Fed’s announcements on Wednesday fairly easily.

The statement released by the Federal Open Market Committee was the most downbeat of the entire year to date. After months of telling us that the slowdown was caused by temporary factors that would ameliorate before the end of the year, the Fed was forced to acknowledge that there are “significant downside risks to the economic outlook.”

So the Fed took action, and while the steps it unveiled were more aggressive than most people expected, and certainly constituted a rebuke to GOP congressional leaders who were telling it not to do anything, the strategy isn’t going to be enough to make a significant difference. That’s a downer: When you acknowledge seriously deteriorating conditions but take insufficient action to address them, you inject more fear into the markets.

So what exactly did the Fed do? What is Operation Twist?

There are two key elements.

First, the Fed announced that, over the next nine months, it would sell $400 billion worth of short-term government securities and buy $400 billion worth of long-term government securities. This doesn’t change the overall Fed balance sheet, so it can’t be caricatured as “printing money.” But what it does do is change the average length of duration of the securities that the Fed is holding.

And that, in turn, means that there will be fewer long-term securities available on the open market for other investors to buy. Scarcity will increase demand, and in consequence, the yields on those bonds — the interest rates that the U.S. government has to offer to attract buyers — will fall. This will effectively lower borrowing costs throughout the entire country. And theoretically, that should stimulate economic activity.

Second, the Fed announced that it would reinvest the cash from expiring mortgage-backed securities into new mortgage-backed securities. This represents a reversal of the Fed’s previous strategy, which was to allow its huge portfolio of mortgage-backed securities to gradually shrink. The result of this reversal should be downward pressure on mortgage interest rates, which would, again theoretically, result in an upsurge in refinancing and a boost to the housing market.

Economists generally agree that these moves will have some impact. The problem is that they just don’t expect it to be very large. Borrowing costs are already very low, but gunshy banks just aren’t willing to make loans, no matter how cheap the cost of capital. The main problem afflicting the U.S. economy is a massive shortfall of demand, and tinkering at the margins with interest rates isn’t going to change much. As Paul Krugman pithily put it, the Fed’s action is like “using a water pistol to stop a charging rhino.”

However, the fact that the Fed felt compelled to make these moves, even after receiving a letter from the Republican congressional leadership demanding that it take no “extraordinary interventions” in the economy, and in the context of Republican presidential candidates declaring that such intervention is “treason,” is all the proof we need that the U.S. economy is in trouble.

What the Fed announced yesterday is hardly “treason,” by any sane interpretation. One could even argue that it doesn’t measure up to the level of “extraordinary.”

But it’s also not enough to cure what ails us, and that’s why markets are plummeting.

: Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21. More Andrew Leonard

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Fed to shift $400B in holdings to boost economy

Move to rebalance $2.87 trillion portfolio could help lower Treasury yields and reduce rates on loans

By Martin Crutsinger, Associated Press

FILE - In this Sept. 30, 2010 file photo, Federal Reserve Chairman Ben Bernanke testifies on Capitol Hill in Washington. The last time the Federal Reserve came up with a big plan to help the economy, it totaled $600 billion and touched off a 28 percent rally in the stock market. But if the Fed takes any new steps, as many people expect, it wont look anything like that. Look for small ball, not a home run. Operation Twist, as Fed-watchers are already calling it, in a nod to economic history, probably will help the economy and the stock market. (AP Photo/Manuel Balce Ceneta, File) (Credit: AP)

Topics:Federal Reserve

The Federal Reserve says it will sell $400 billion of its shorter-term securities to buy longer-term holdings, its latest effort to boost a weak economy.

The Fed’s move to rebalance its $2.87 trillion portfolio could lower Treasury yields further. Ultimately, it might reduce rates on mortgages and other consumer and business loans.

The Fed also said it will reinvest its holdings of mortgage-backed securities, which would help keep mortgage rates at super-low levels. The Fed had previously reinvested the interest and principal into Treasury purchases.

Fed policymakers announced the moves Wednesday after a two-day meeting. Three members dissented from the decision.

“The actions the Fed has taken are helpful,” says Josh Feinman, global chief economist at DB Advisors. “They will help hold down long-term rates, but they’re no panacea.”

Stocks fell immediately after the announcement. The Dow Jones industrial average dropped 100 points. The yield on the 10-year Treasury note tumbled, and its price rose.

In its statement, the Fed noted that the economy is growing slowly, unemployment is high and housing remains in a prolonged slump.

As a result, the Fed has directed the New York Fed to purchase Treasurys with remaining maturities of six to 30 years, and to sell an equal amount of securities with maturities of three years or less.

Many analysts have said the shift in the Fed’s portfolio could provide modest help by reducing borrowing costs and perhaps raising stock prices. Others say it won’t help and warn that the move could escalate inflation.

In June, the Fed completed a $600 billion bond-buying program that may have helped keep rates low.

Expectations that the Fed would expand its holdings of long-term securities, along with fears of another recession, have led investors to buy up U.S. Treasurys. Treasury yields have dropped in response.

Once the Fed announced last month that it would expand its September policy meeting from one to two days, economists have anticipated some new action from the Fed. Chairman Ben Bernanke had said the Fed was considering a range of options.

The central bank is under pressure to revive an economy that has limped along for more than two years since the recession officially ended.

In the first six months of this year, the economy grew at an annual rate of just 0.7 percent. The housing market remains depressed. The unemployment rate is 9.1 percent. In August, the economy didn’t add any jobs, and consumers didn’t increase their spending on retail goods.

Most economists foresee growth of less than 2 percent for the entire year. They say the odds of another recession are about one in three.

The Fed has offered its own bleak outlook. At its August policy meeting, it said the economy would likely struggle for at least two more years. As a result, it said it planned to keep short-term rates near record lows until mid-2013, as long as the economy remained weak.

The Fed’s move Wednesday came despite a rift within the central bank. Three members also dissented from the Fed’s decision at its August meeting — the most negative votes in nearly two decades. The three, all regional Fed bank presidents, have said the Fed’s policies may be raising the risk of high inflation.

Bernanke’s policymaking has also incited criticism from congressional Republicans and GOP presidential candidates. Some have argued that the Fed’s $600 billion bond-buying program, which ended in June, raised inflation pressures, weakened the dollar’s value against other currencies and contributed to a spike in oil prices.

On Monday, the four highest-ranking Republicans in Congress sent Bernanke a letter cautioning the Fed against taking further steps to lower interest rates. Their letter suggested that lower rates could escalate the risk of high inflation.

Texas Gov. Rick Perry, who is seeking the GOP nomination for president, has gone so far as to say Bernanke would be “almost treasonous” to launch more bond buying.

The Fed’s efforts to stimulate the economy through low rates are occurring at a time when Congress is focused more on shrinking spending.

President Barack Obama has proposed a $447 billion job-creation program made up mainly of tax cuts and public works spending. Obama also wants the richest Americans to pay higher taxes to help cut federal budget deficits.

Obama’s proposals face an uncertain fate in Congress. Republicans have dismissed his deficit-reduction plan and have focused on efforts to reduce spending and keep taxes low for everyone.