Fed Leaves Fed Funds Rate Near Zero; Prepared To Buy Treasurys

By Brian Blackstone andMaya Jackson Randall
Of DOW JONES NEWSWIRES

WASHINGTON -- U.S. Federal Reserve officials on Wednesday signaled they're prepared to move forward on a controversial idea to purchase longer-dated Treasury securities, which would mark a dramatic escalation of their efforts to unclog credit markets.

The Federal Open Market Committee voted 8-1 to maintain the target federal funds rate for interbank lending at a record-low range of zero to 0.25%. The interest rate and balance sheet decisions are aimed at combating a worsening recession and deflationary spiral of falling employment and spending.

Richmond Fed President Jeffrey Lacker dissented, preferring an expansion of the monetary base rather than targeted credit programs. It was Lacker's fifth-straight dissent dating back to his last turn as a voting FOMC member in 2006.

The Fed also held the discount rate for direct loans to commercial and investment banks unchanged at 0.5%.

Rates will likely stay where they are well into the year if not into 2010, the accompanying policy statement suggested, especially with officials now signaling that deflation may be a risk.

"The economy has weakened further" and while a gradual economic recovery is expected to begin later this year, downside risks to this outlook are "significant," the FOMC said, while conditions "are likely to warrant exceptionally low levels" on fed funds "for some time."

With the Fed unable to lower rates further and the economy in need of more stimulus, officials appear poised to purchase longer-maturity Treasury securities as a way to keep interest rates low.

The FOMC "is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets," the FOMC said.

Fed Chairman Ben Bernanke first floated the idea almost two months ago, saying the Fed "could" make those purchases. The FOMC said in last month's policy statement that it was "evaluating" the idea and repeated that in meeting minutes. Bernanke stuck with "evaluating" in a speech two weeks ago.

Wednesday's statement was more concrete, suggesting officials are close to executing such a plan or else risk a severe fallout in credit markets if they don't follow through.

"It is highly likely that the Federal Reserve will eventually decide to purchase longer-term Treasury securities," said economists at Goldman Sachs in a research note before the FOMC decision.

However, Lou Crandall, an economist at Wrightson ICAP, calls the idea "terrible."

"If you tell international investors that returns on Treasurys are going to be artificially depressed for years to come, you may force them" out of other types of U.S. dollar-denominated debt like corporate and mortgage backed securities and into foreign debt like Japanese and German government bonds, Crandall said.

Until recently the Fed's strategy was two-pronged: lower Treasury yields via steep cuts in the federal funds rate and reducing the spread between Treasury yields and those of other consumer, business and homeowner loans through credit programs funded through an increase in bank reserves -- a process known as quantitative easing. The focus is now on the latter.

The Fed's balance sheet will likely stay "at a high level," the Fed said Wednesday, and officials will assess "whether expansions of or modifications to lending facilities would serve to further support credit markets and economic activity and help to preserve price stability."

The Fed is already in the early stages of a $500 billion plan to purchase agency-backed mortgage backed securities by the end of the second quarter, having bought a little over $50 billion so far in January. It also plans next month to begin a $200 billion lending facility to support the asset-backed securities market made up of loans for small businesses, consumers, credit cards and automobiles.

The U.S. just closed the books of what's likely to be the largest gross domestic product contraction in almost three decades last quarter. The economy has shown no sign of stabilizing at the start of 2009, as had been hoped.

The economy is losing about one-half million jobs a month, and this week on a particularly brutal Monday several companies including Caterpillar Inc. (CAT), Sprint Nextel Corp. (S), Pfizer Inc. (PFE), Home Depot Inc. (HD) and General Motors Corp. (GM), all announced significant layoffs. Many firms are also instituting salary freezes.

That mix has led to a severe slide in consumer confidence to historic lows in turn threatening consumer spending, which makes up roughly 70% of economic activity.

Meanwhile, the Fed seems unconcerned that the stimulative mix of near-zero interest rates and quantitative easing steps will lead to an inflation outbreak anytime soon. Consumer prices nudged up just 0.1% in 2008, a government report earlier this month showed, the slimmest calendar-year increase since the 1950s.

The Fed "sees some risk" that inflation "could persist for a time below rates that best foster economic growth and price stability," the FOMC said.

Wednesday's decision was the first of the FOMC's fresh lineup of voting regional bank presidents including newly installed New York Fed President William Dudley.

New Fed Governor Daniel Tarullo, who was confirmed late Tuesday by the Senate, didn't participate in the meeting.

(Tom Barkley and Jeff Bater contributed to this article)

-By Brian Blackstone and Maya Jackson Randall; 202-828-3397; brian.blackstone@dowjones.com and maya.jackson-randall@dowjones.com