Should the Fed try to push long-term interest rates even lower?

If the economy were careening into another recession, Federal Reserve policymakers would know exactly what to do: Rent out the Air Force, print money and rain it all over America.

Figuratively speaking, of course.

They’d also know what to do if the recovery began to accelerate, pushing up the inflation rate. That’s in the first chapter of the Central Banking 101 textbook: You start tightening credit by raising short-term interest rates.

The current state of affairs, however, is much more of a challenge for the Fed. If the economy is just going to muddle through for an extended period, what’s appropriate central bank policy?

The Fed might just prefer to sit still. But after the government’s report Friday that the economy lost jobs in July, the pressure is certain to intensify on policymakers to do something.

With the Fed’s benchmark short-term interest rate already near zero, that gun is out of bullets. That leaves long-term rates.

On Tuesday, when Fed policymakers hold their midsummer meeting, they’re expected to take up the question of whether to try to engineer a further decline in long-term interest rates, such as on government and corporate bonds and on mortgages.

How? Most likely by reprising their 2009 program of creating money out of thin air to buy Treasury and mortgage-backed bonds in the open market.

Yet even if the Fed were to succeed in pulling long-term interest rates lower, the question is whether it would make a difference in the economy.

“I don’t see a big benefit,” said Joe Carson, head of economic research at money manager AllianceBernstein in New York. “I don’t think the price of credit is the issue.”

Job creation, he said, is about “confidence in the outlook.” And to that end, lower rates could even backfire by fueling renewed pessimism about the economy’s trajectory, if consumers, executives and business owners see a Fed shift as a desperation move.

Just a few months ago the Fed wasn’t expecting to face a call for easier money. The recovery had momentum after the V-shaped rebound in the second half of 2009 from the devastating recession. By April the talk had turned to potential inflation pressures.

Now it’s clear that the momentum has faded. The economy is growing, but it has slowed markedly in recent months.

Consumers’ confidence level has declined since May, and their spending has decelerated. An index of manufacturing activity has fallen for three straight months, though it’s still signaling expansion.

Wall Street optimists say this is a normal slowdown after a brisk initial rebound. That might be fine — except for the dismal state of the labor market.

On Friday, the government said the economy lost a net 131,000 jobs in July as temporary U.S. census workers were dismissed. More disheartening was that the private sector created only a net 71,000 jobs in the month. And the private-sector figure for June was revised down to 31,000 from 83,000.

At this rate of hiring there is little hope of making much more of a dent in the national unemployment rate, which remained stuck at 9.5%.

In testimony before Congress in late July, Fed Chairman Ben S. Bernanke said that the central bank considered the economic outlook to be “unusually uncertain,” citing in part the “slow recovery in the labor market.”

Bernanke also said that the Fed would “remain prepared to take further policy actions as needed” to protect the economy. Yet he stressed in his testimony that “we’re not prepared to take any specific steps in the near term, particularly since we’re still also evaluating the recovery, the strength of the recovery.”

This week, however, some worried Fed policymakers signaled the possibility of reviving the central bank’s purchases of mortgage-backed bonds and/or U.S. Treasury bonds.

The Fed, recall, late in 2008 committed to buying $500 billion of mortgage securities for its own portfolio. In March 2009 it raised its mortgage-bond purchase commitment to $1.25 trillion, and launched a separate program to buy $300 billion of Treasury securities.

One key goal of both programs was to put downward pressure on long-term interest rates to help the battered economy, and specifically to help the housing market. The concept of trying to influence interest rates via direct bond purchases is known as “quantitative easing” — or QE for short.

There’s no way to precisely quantify how much lower long-term interest rates were in 2009 because of the Fed’s massive bond purchases, which ended in March of this year. But the programs obviously helped restrain rates.

Now, with the economy losing steam, some Fed officials have said publicly that bond purchases could be restarted on a smaller scale. The idea would be to use the proceeds from maturing bonds in the Fed’s giant portfolio to buy more debt, rather than simply allowing the portfolio to continue to run off.

After Friday’s jobs report, the Treasury bond market saw a new Fed push as a virtual certainty: The two-year Treasury note yield ended the week at a record-low 0.49%, down from 0.55% a week earlier.

The 10-year T-note yield, a benchmark for mortgage rates, tumbled Friday to a 15-month low of 2.82% from 2.91% on Thursday and nearly 4% in early April.

“We expect the [Fed] to respond to renewed upward pressure on the unemployment rate with another round of unconventional monetary easing,” Goldman, Sachs & Co. economists said in a report Friday. “These measures could involve more asset purchases — probably Treasury securities,” they said.

But some Fed-watchers think that a decision to resume bond purchases on a limited scale would be a mistake. Lou Crandall, economist at Wrightson ICAP in Jersey City, N.J., said it would amount to “empty symbolism” that would damage the central bank’s credibility.

And does the Fed really need to do more with interest rates if the economy is just muddling through rather than falling off a cliff?

Another decline in rates would help the same groups that already have no trouble borrowing — Fortune 500 companies, for example, the U.S. Treasury and two-income families with high credit scores and ample assets.

Yet lower mortgage rates wouldn’t do anything for people who desperately want to refinance their current home loans but have no equity in their houses.

“The bang for the buck is low” in cutting rates further, said Ethan Harris, head of North American economics at Bank of America Merrill Lynch.

On the other side of the ledger, falling bond yields mean the horde of investors clamoring to buy fixed-income securities are locking in at even less attractive interest rates.

AllianceBernstein’s Carson offers another reason the Fed should think twice about pushing rates lower: It could trigger a steep new sell-off in the dollar, which has been sliding against its major rival currencies since early June.

The weaker greenback has been good for U.S. exporters. But another decline in interest rates risks whipping up an anti-dollar frenzy that could frighten global investors — including the Chinese, who hold more than $1 trillion in Treasury securities.

“I would be very worried about negative reaction in the currency market,” Carson said. On Friday the dollar lost ground, though there was no panic selling.

Last, there’s this: Anything the Fed does to suggest that the economy needs more help could just reinforce pessimism and give businesses another reason to go slow in hiring and spending money.

Indeed, there’s an argument that modestly raising short-term rates could do more to spur the recovery than hurt it, by signaling that the emergency that required near-zero rates has passed.

The Fed isn’t going to make that move any time soon. But just holding the line at this point might be a better strategy than rewarding borrowers who don’t really need the Fed’s help.

tom.petruno@latimes.com