Fed preview: More upbeat, but not about spending trillions

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The challenge for the Federal Reserve in its post-meeting statement today: Persuade investors that the economy is slowly getting better -- and that it won’t take another $2 trillion in Fed aid to keep things on track.

Chairman Ben S. Bernanke and peers are likely to use their statement to sound slightly more upbeat about the economy, given recent data on GDP, manufacturing and employment.

But they may not deviate much from their June meeting summary, because the basic facts haven’t changed: ‘The pace of economic contraction is slowing,’ the Fed said in June. That’s still true -- we hope.

Likewise, the Fed will almost certainly repeat that it expects to keep its benchmark short-term interest rate near zero ‘for an extended period.’ Many Fed-watchers believe there is no chance of a rate hike before mid-2010, at the earliest.

Then what’s left for the Fed mandarins to discuss? The trillions of dollars they’ve pumped into the financial system to keep it afloat -- and when they might begin to take some of that cash back.

With the economy showing signs of improvement, Bernanke and other Fed officials have been forced this summer to address the question of an ‘exit strategy’ for the alphabet soup of lending programs they’ve created, ballooning the central bank’s balance sheet to $2 trillion.

Bond investors fear that too much of the money will eventually get into the real economy and stay there, fueling an inflation surge. The Fed, not surprisingly, insists that it’ll be able to vacuum up that money fast enough -- once the economy is growing -- to avoid an inflation breakout.

If Bernanke & Co. want to throw a bone to the exit-strategy crowd, they could easily do so today by saying they’ll allow their program of buying Treasury securities to expire as planned when purchases reach $300 billion in September.

The goal of the Treasury buyback plan, launched last winter, was to restrain government bond yields amid the Obama administration’s massive borrowing wave. But Treasury note and bond yields have risen anyway this year, in large part because investors are eschewing government debt in favor of riskier assets such as stocks.

At this point, ‘The Treasury purchase program is embarrassing and becoming more so’ for the Fed, said Michael Kastner, head of fixed income at Sterling Stamos Capital Management in New York.

But the central bank isn’t about to call off its more important program of buying $1.25 trillion in government agency mortgage-backed securities by year’s end.

‘In the mortgage market, they are the buyer,’ said Steven Stanley, chief economist at RBS Securities in Stamford, Conn. That makes the Fed a crucial element of the Obama administration’s strategy of using Fannie Mae and Freddie Mac to refinance loans of underwater homeowners.

What’s more, the Fed may be forced to ante-up more aid for the deeply troubled commercial real estate sector, a market Bernanke last month said he’s ‘paying very close attention’ to.

All told, the Fed has already warned that its balance sheet is likely to expand further by year’s end, to about $2.5 trillion.

Since the financial system collapse last fall, the Fed has repeatedly reminded markets that there is no limit to the amount of credit it can create. But policymakers have to be more careful about their boasting now: If $2.5 trillion begins to look more like $3 trillion or $4 trillion, the Fed and the administration could face their -- and our -- worst nightmare: A sudden buyers’ strike by inflation-paranoid bond investors, triggering the Mother of All Credit Crunches.

-- Tom Petruno