Fed will try to shave long-term interest rate

Stock markets drop after announcement

9/22/2011

WASHINGTON -- The Federal Reserve will use more than $400 billion to try to drive down long-term interest rates, make home and business loans cheaper, and invigorate the economy.

Analysts said the moves would provide only a slight economic benefit.

The action the Fed announced yesterday is modest compared with previous steps it has taken. The Fed will not expand its $2.9 trillion holdings; it is just rebalancing them.

It will sell $400 billion of its shorter-term Treasurys to buy longer-term Treasurys by June, 2012. And it will reinvest principal payments from its mortgage-backed securities to help keep mortgage rates at super-low levels.

Fed policymakers announced the moves after a two-day meeting. Three members out of 10 dissented from the decision. The Fed acted despite criticism from Republicans who have warned that such steps could ignite inflation.

"The actions the Fed has taken are helpful," says Josh Feinman, global chief economist at DB Advisors. "They will help hold down long-term rates, but they're no panacea."

The Fed left open the possibility of taking further action to try to strengthen the economy.

Stocks dropped immediately after the announcement and then continued falling. The Dow Jones industrial average closed down about 283 points. All the major stock indexes fell 2 to 3 percent.

The plan the Fed unveiled yesterday, dubbed "Operation Twist," resembles a program the Fed used in the early 1960s to "twist" long-term rates lower relative to short-term rates. In its statement, the Fed noted that the economy is growing slowly, unemployment is high, and housing remains in a prolonged slump.

Under its plan, the Fed will extend the average maturity of its holdings from six years to eight years. The Fed has directed the New York Fed to buy Treasurys with remaining maturities of six to 30 years, and to sell an equal amount of securities with maturities of three years or less.

Analysts say the shift in the Fed's portfolio could reduce borrowing costs and perhaps raise stock prices.

"This is a measured response to weak economic conditions," said David Jones, head of DMJ Advisors and the author of four books on the Fed. "The Fed is still trying, but it can only do so much."

In June, the Fed completed a $600 billion bond-buying program that many economists have credited with keeping rates low.

The central bank is under pressure to revive an economy that has limped along over two years since the recession officially ended.