Published March 20, 2009

Fed throws in US$1.2t and the kitchen sink

Aggressive action seen raising odds for recovery

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(WASHINGTON) The Federal Reserve said on Wednesday that it will deploy an additional US$1.2 trillion to try to lower interest rates and stimulate the economy, an aggressive move aimed at containing the recession.

The central bank will increase its purchases of mortgage-backed securities by US$750 billion, on top of a previously announced US$500 billion.

It also will double its purchases of debt in Fannie Mae and Freddie Mac to US$200 billion. Those steps are intended to lower mortgage rates. The announcement of the previous purchases pushed mortgage rates down a full percentage point.

The surprise news also had an immediate effect on the financial markets. The Dow industrials posted their sixth gain in seven trading days, while long-term interest rates plummeted - exactly the reaction that the Fed wanted.

The Fed's latest move - coupled with an unprecedented panoply of previous steps by the government to fix the financial crisis and stimulate spending - makes it more likely that the country's 15-month-old recession will end by the end of this year, with economic growth resuming early in 2010, economists said.

'They are trying to fire absolutely every weapon they can,' said Nigel Gault, chief US economist at forecasters IHS Global Insight. 'It improves the odds that we'll bottom out in the second half of the year.'

But the action also increases the risk that inflation, which has been dormant for the last year, could spring back to unwelcome heights. That danger sent the value of the dollar down against other currencies and boosted the market price of gold by about US$50 an ounce, putting it back above US$900.

The prospect of recovery, however, cheered the stock market, which had been down for the day before the Fed's announcement. The Dow Jones industrial average closed up 90.88 points, or 1.2 per cent, at 7,486.58. The broader Standard & Poor's 500 stock index surged 2.1 per cent.

Since hitting 12-year lows early last week, the Dow has jumped 14 per cent and the S&P is up 17 per cent.

In the bond market, the yield on 10-year Treasury notes - considered a benchmark for home-loan rates - fell by about half of a percentage point, suggesting that mortgage rates could fall that much.

The Mortgage Bankers' Association said on Wednesday that the average 30-year loan rate fell to 4.89 per cent last week, down from 4.96 per cent the week before.

David M Jones, a former Fed economist now with DMJ Advisors in Denver, said that mortgage rates could drop by a full point. 'If you bring the interest rate down that much, we'll have a huge amount of refinancings,' he said.

'I've never known when the Fed has taken a move this powerful in easing monetary policy,' he added.

Lower home-loan costs could set off a series of beneficial effects.

Smaller monthly payments for homeowners who refinance could stimulate consumer spending. More-affordable mortgages also would encourage people to buy homes, and allow more people to qualify for a loan, helping to stabilise the housing market, considered to be the main source of the problems confronting the financial markets and the economy.

If housing does stabilise, the wave of huge mortgage-related losses recorded by banks could begin to dry up. In the meantime, troubled banks could benefit from a surge in revenue by issuing new mortgages.