Washington » Anticipation is high that the Federal Reserve will announce some new step Wednesday to try to rejuvenate the U.S. economy and boost investor confidence.
Just what that might be is unclear.
One option would be an effort to drive long-term interest rates even lower to try to spur borrowing and spending. A more modest step would be for the Fed to stress its readiness to do more should the economy weaken further.
Or the Fed might do or promise nothing further — not for now, anyway.
Yet Wall Street rallied Tuesday on hopes that the Fed will announce when its two-day meeting ends Wednesday that more help is on the way.
Chairman Ben Bernanke and other Fed officials have acknowledged the slumping U.S. economy and the threats posed by Europe’s debt crisis. At the least, analysts expect the Fed to say or unveil something to signal that it’s willing to provide further support.
The Fed has kept its key policy lever, the federal funds rate, at a record low near zero since December 2008. And it’s said it plans to keep it there until at least late 2014.
Given that it can’t cut short-term rates any further, the Fed has tried to further reduce long-term rates by buying more than $2 trillion in Treasury bonds and mortgage-backed securities. The idea is for those lower rates to help boost spending, hiring and economic growth.
Here’s a look at the Fed’s options, in order of their perceived likelihood:
Extend Operation Twist » Under this initiative, the Fed has been gradually selling $400 billion in short-term Treasury securities since September and using the proceeds to buy longer-term Treasurys.
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In doing so, the Fed seeks to "twist" long-term rates lower relative to short-term rates. Operation Twist has the advantage of potentially lowering long-term rates without expanding the Fed’s record-high portfolio. When the Fed expands its portfolio of investments, critics argue that it raises the risk of high inflation later.
Operation Twist is set to expire at the end of the month. Many analysts say the Fed will announce it will continue to swap short-term securities it owns for longer-term securities for a few more months. But the benefit would likely be slight. The Fed has a dwindling supply of short-term securities it can swap. Some think any new Operation Twist would be only about half the size of the expiring program.
Others note that even if Operation Twist did nudge long-term rates slightly lower, it probably wouldn’t provide much benefit. Long-term U.S. rates have already touched record lows. Businesses and consumers who aren’t borrowing now might not be moved to do so if rates slipped a bit more.
QEIII » When the Fed expands its portfolio by buying more bonds, it’s called quantitative easing, or QE. It’s already engaged in two rounds of QE totaling more than $2 trillion.
A possible third round would be the most dramatic move the Fed could make to try to further drive down long-term rates. It would also trigger the most criticism because it would expand the Fed’s holdings by billions more dollars.
Opponents warn that further bond purchases would do little to help and would risk high inflation in the future. The Fed might also eventually find it harder to shrink its portfolio without driving interest rates back up and threatening the economy.
Supporters of further bond purchases counter that last week’s news that consumer prices fell in May by the most since late 2008 showed that inflation is hardly a threat. Rather, they argue, the most urgent problems are the job market and the economy, which continue to struggle.
More bond purchases, if they did help lower rates, could also lift the stock market if they led many investors to shift money out of low-yielding bonds into stocks. The Securities Industry and Financial Markets Association issued a survey Tuesday showing that two-thirds of the Wall Street economists it surveyed expect the Fed to announce more bond buying.
Stronger language » Under this option, the Fed would change the wording of the statement it issues after each meeting. It could do so in two ways. It could be more definitive in pledging to help should the economy weaken further and perhaps spell out what those steps could be.
Or it could push back the timetable when it expects to begin raising short-term rates beyond its current target of late-2014, until some time in 2015.
Do nothing » This would represent a continuation of the Fed’s decisions at its policy meetings in March and April. After each of those meetings, it kept its policy-making on hold.
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