Decision time for the Fed: Do more for the economy, or wait?

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A few weeks ago, Tuesday’s Federal Reserve meeting was expected to be a non-event. Now it has become a summer cliffhanger.

With the U.S. economy clearly slowing, job creation still abysmally weak and fear of deflation a hot topic in financial markets, the Fed has to decide whether to launch new programs to support the recovery.

Programs, like what? There’s no point in the Fed cutting its benchmark short-term interest rate, which already is near zero. So analysts who expect the central bank to act figure that policymakers will focus on trying to pull long-term interest rates down further.

The Fed could do so by returning to so-called quantitative easing, or QE. One option under QE would be for the Fed to resume buying Treasury bonds and/or mortgage-backed bonds for its own account, adding to the $1.7 trillion in securities it bought from January 2009 to March of this year.

By taking another chunk of Treasuries or mortgage-backed securities off the market, the Fed could put downward pressure on bond yields. It also would put more money into the financial system and economy by buying securities from investors, banks and others in return for cash. In theory, at least, that would be a pro-inflation, anti-deflation move.

The bond market seems to be betting that more Fed help is coming. Treasury yields tumbled Friday after the government’s disappointing July employment report stoked expectations for another round of QE.

On Monday yields were little changed ahead of the Fed meeting. The 10-year T-note yield ended unchanged at a 15-month low of 2.82%, down from 3.3% in mid-June. If the Fed disappoints bond bulls, yields could whiplash on Tuesday, traders warn.

Yet Wall Street is divided on whether the Fed will feel compelled to act, according to a survey of 21 big money managers Monday by market research firm Reid Thunberg ICAP: Forty-eight percent of the managers expect the Fed’s post-meeting statement to hint at new credit-easing moves, while 52% think policymakers will stand pat.

Many of those who anticipate a resumption of the QE program expect it would be a relatively small step. The Fed could, they say, just commit to using the money earned on its current massive bond portfolio to buy additional securities, rather than allowing its holdings to continue to run off as securities mature.

Ian Shepherdson, economist at High Frequency Economics, figures that reinvesting bond proceeds would allow the Fed to put about $200 billion more into the bond markets over the next year. That “is not the full-blown return to quantitative easing we want to see, but it is a big step in the right direction, and it should help to maintain the downward pressure on Treasury yields,” he said.

As I noted in my weekend column in The Times, some economists say the Fed could look desperate by announcing another round of QE. That camp argues that the Fed should instead wait to see if the economy picks up speed again in the next few months. Besides, those analysts note, lowering long-term interest rates further just benefits those who can already easily get credit, such as Fortune 500 companies.

But the Fed may be more worried about a deflation mind-set taking hold than about actual levels of long-term interest rates. By at least signaling that they’re ready to do more quantitative easing -- thereby pumping more cash into the economy, in the hope of getting the gears to turn faster -- Chairman Ben S. Bernanke and peers could show their resolve to do whatever it takes to keep the U.S. from falling into a Japan-style deflationary spiral.
-- Tom Petruno