Fed adds $1.2 trillion to rescue

WASHINGTON – The Federal Reserve Wednesday escalated its massive campaign to stabilize the economy, saying it would flood the financial system with an additional $1.2 trillion.

The decision by the Fed to buy government bonds and mortgage-related securities is designed to lower borrowing costs for home mortgages and other types of loans, thereby stimulating economic activity. The central bank, effectively, will print more money to pay for the purchases.

Combined with the billions already deployed by the Fed, the new money dwarfs even the biggest government bailouts of financial companies.

Wednesday’s announcement amounts to a recognition by Fed leaders that the economy has gotten much worse than they had forecast at their last policymaking meeting, in January. It also is their attempt to show market participants that, three months after cutting short-term interest rates to zero, they still have more tools to try to bolster the economy.

Financial markets surged on news of the decision, with the Standard & Poor’s 500-stock index up 2.1 percent for the day.

The new purchases come with risks. They will balloon the value of the assets the Fed holds by about 50 percent, to more than $3 trillion. That could make it tricky for the central bank to suck that money out of the system once the economy starts to recover. The Fed would probably find it difficult to sell such massive volumes of assets, and if it doesn’t handle the task adeptly, the nation could face high inflation because too much money would be in circulation.

“This will help the economy,” said John Silvia, chief economist at Wachovia. “The challenge comes nine months from now, when the economy starts to recover and the Fed finds itself in a very delicate position. The challenge is the exit strategy.”

The newest intervention includes a plan for the Fed to buy up to $300 billion of long-term U.S. Treasury bonds over the next six months. Increased demand for bonds drove down the government’s cost of borrowing money almost instantly Wednesday, with the rate on 10-year Treasurys plummeting by half a percentage point. The dollar fell sharply against other major currencies, highlighting the risk that an increased money supply could cause the currency to lose value over time.

Some Fed leaders have resisted buying Treasurys in the past because they were unsure whether it would help reduce borrowing costs and because they feared that it would appear that the central bank was simply printing money to finance the government’s deficit, a hallmark of countries with poorly managed economies.

Ultimately, in the two-day policymaking meeting that ended Wednesday, the scope of the economy’s deterioration in recent months trumped those concerns.

It helped that the Bank of England took similar steps earlier this month, with positive results.

The action is an example of “quantitative easing,” in which the money supply is increased, a policy famously undertaken by Japan in the 1990s.

In contrast, the Fed has largely tried to stimulate the economy with what Chairman Ben Bernanke has called “credit easing,” a policy in which cash is used to prop up lending.

In its statement Wednesday, the Fed said it will increase its purchases of mortgage-backed securities by $750 billion, on top of $500 billion previously announced, and double, to $200 billion, its purchases of debt in housing-finance firms such as Fannie Mae and Freddie Mac. The earlier purchases pushed rates on a 30-year, fixed-rate mortgage down by about one percentage point, and analysts said that Wednesday’s announcement could reduce mortgage rates by another half of a percentage point.

At the current pace of home-purchase and refinancing activity, the central bank could end up funding 60 to 70 percent of mortgages issued this year, Wachovia economists estimated. “You’ll get some mortgage refinancing, maybe some people on the bubble of foreclosure who are spared,” said Richard Yamarone, chief economist at Argus Research.

The steps are the latest in the Fed’s attempt to stimulate the economy through unconventional means, many of which include massive expansions of the central bank’s balance sheet. At the beginning of September, before the financial crisis deepened, the Fed had $894 billion in assets. That figure had risen to $1.9 trillion last week, and will rise above $3 trillion if the central bank makes the purchases announced yesterday without cutting back in any other areas of its intervention in the economy. The Fed is also preparing other measures to expand lending, most notably a $200 billion consumer lending program. The initial deadline for investors to participate in that program is today.

In the past three months, the Fed’s balance sheet has actually contracted, as conditions in private credit markets have improved enough that fewer companies have taken advantage of Fed programs to supply cash. While it was considered good news that private lending was showing signs of life, it was bad news in the sense that the Fed believes its massive balance sheet is the key tool to support the U.S. economy more broadly.

That expansion of the balance sheet could pose some difficult dilemmas down the road. Some of the new programs the Fed has launched will unwind automatically – and fairly quickly – as the financial system stabilizes.

But it will be harder to deal with long-term securities like those the Fed is now buying. Having them on the bank’s books could make it harder to reverse course and shrink the money supply when the economy starts to strengthen, causing inflation.

That said, “that’s a good problem to have,” said Neal Soss, chief economist at Credit Suisse, in that it means the economy would have returned to growth. “When the house is burning down, you put out the fire. If in the process you get the furniture wet, you worry about that later.”