US economy gets $1.2 trillion boost

In addition to purchasing treasury debt, the central bank said it would expand by $850bn an existing programme to buy debt and securities issued by mortgage finance agencies to $1.45 trillion, in an effort to lower mortgage rates.

‘Dramatic move’

The Fed also sent a strong signal that it would keep interest rates low. It decided to leave overnight interest rates unchanged at the 0 to 0.25 per cent range and said  rates would stay low for “an extended period”, a stronger pledge than it has offered in recent months.

In depth

And it said it would consider expanding another $1 trillion programme that is being rolled out this week that aims to boost the availability of consumer loans for cars, education and credit cards, as well as for small businesses.

The decision to hold rates near zero was widely expected, but the plan to buy government bonds and the size of the injection into the economy was a surprise.

“This is a pretty dramatic move… They are trying to bring down all consumer rates,” said James Caron, head of global rates research at Morgan Stanley in New York.

Rick Meckler, the president of Libertyview Capital Management in New York, explained the central bank’s move as “an attempt to keep rates low, particularly on the mortgage side, which is seen as critical to a big revival of the housing market”.

Having pushed key interest rates to almost zero, the central bank has turned its focus to flooding credit markets with cash in the hope of restarting lending and restoring growth, a policy Ben Bernanke, the Federal Reserve chairman, has dubbed “credit easing”.

Cheaper money

Buying government bonds in such huge amounts would usually have the effect of causing bond prices to soar and yields on the bonds to plunge.

Buying bonds

Buying government bonds from financial institutions in massive amounts increases demand for them, thereby raising their price. Prices of bonds generally have an inverse relationship with their yields as well as with interest rates, meaning lending rates will fall. Treasury rates tanked dramatically on the Fed’s move. Lower interest rates mean consumers and businesses can spend less on paying for their loans, freeing up money to spend on other things. But the Fed buys the bonds by printing new money without real assets to back that up, increasing the risk of inflation. And increased supply of dollars also means the value of the dollar falls.

And the central bank is hoping that by driving down yields on the debt and making it cheaper to borrow money, it will get credit flowing again and from that, economic growth.

The Fed had hinted in January that it was considering buying government debt but in recent weeks had appeared to back off from the move.

William Dudley, the New York Federal Reserve president, said two weeks ago that buying longer-term government debt was not the most efficient way to ease credit market strains.

But the Bank of England, which like the US Federal Reserve had already lowered its key interest rate to a record low – 0.5 per cent, managed to drive interest rates down last week by buying government bonds, and that success may have factored into the US central bank’s decision.

And in a sign that it might just work, government bond prices soared on Wednesday and the yield on the benchmark 10-year treasury note dropped to 2.50 per cent from 3.01 per cent – the biggest daily drop in percentage points since 1981.

Sung Won Sohn, an economist at the Martin Smith School of Business at California State University, said the Federal Reserve’s move was “going to help everybody”.

“This might help the Fed put Humpty Dumpty back together again.”

Inflation fears

But not everyone was cheering, with some warning of long-term inflation with the Fed printing money to buy the bonds.

“It’s overtly inflationary and will inflate most assets,” said Joseph Arsenio, the managing director at Arsenio Capital Management in California.

Greg Salvaggio, a vice-president for trading at Tempus Consulting in Washington, said the “bottom line is the Fed is adding a trillion dollars to their balance sheet and that’s a lot of taxpayer money”.

The dollar fell against other major currencies on Wednesday, a possible signal over concerns that the Fed’s intervention might spur inflation over the long run.

The Fed has said it is mindful of the risks but said on Wednesday that since it last met in late January, “the economy continues to contract”.

“Job losses, declining equity and housing wealth and tight credit conditions have weighed on consumer sentiment and spending,” it said in a statement.

Bernanke had said in recent weeks that if credit and financial markets could be stabilised, the recession could end this year, setting the stage for a recovery next year.

But the Fed’s statement on Wednesday did not have any specific reference to the likelihood of the recession ending this year, saying instead that the near-term outlook was “weak” and only that stimulus measures should lead to a gradual resumption of growth.