Q&A: How the Fed move could affect the economy and markets

The Federal Reserve on Wednesday announced a new thrust in its efforts to bolster the struggling economy. Here’s a look at what the central bank will do and the potential effects across the economy and markets.

What did the Fed announce?

With short-term interest rates already near zero, the Fed hatched a new plan to drive down longer-term interest rates — including mortgage rates — as a way to stimulate economic growth.

How does the Fed expect to push longer-term rates down?


Policymakers will manipulate their $2.65-trillion portfolio of U.S. Treasury and mortgage-backed bonds, most of which have been acquired since 2007. Over the next nine months the Fed plans to sell $400 billion of the shorter-term Treasuries it owns and use the proceeds to buy bonds maturing between six and 30 years from now.

By increasing demand for longer-term bonds the Fed hopes to boost the prices of those securities, which in turn would lower market interest rates. As bond prices rise the rates, or yields, on the securities decline.

How would lower Treasury bond yields drive down other interest rates?

Treasury yields are the benchmarks for rates in general, so as they rise or fall they tend to pull other rates along with them.


Was this shift toward longer-term bonds a surprise?

Wall Street had been expecting the Fed to target long-term rates, but the size of the program was larger than many analysts had anticipated. Also, the Fed said that 29% of the $400 billion that it shifts would target bonds maturing in 20 to 30 years, which also was more than expected, said Justin Lederer, an interest-rate strategist at Cantor Fitzgerald & Co. in New York.

How did the bond market react?

The announcement triggered a new rush of buying in long-term Treasuries, driving yields sharply lower. The yield on the 30-year Treasury bond, the government’s longest-term bond, dropped to its lowest point since early 2009, plunging to 3.00% from 3.20% on Tuesday.

The yield on the 10-year Treasury note, a benchmark that influences mortgage rates, slid to a 60-year low of 1.86% from 1.94%.

Investors and traders snapped up bonds betting that the Fed will succeed in driving rates down and keeping them down. If rates continue to fall, bonds purchased now will rise in value.

But if the Fed is selling shorter-term bonds, won’t that make short-term rates rise?

Possibly. But there is so much demand for Treasuries worldwide as a haven that many analysts believe the effect will be muted. On Wednesday the yield on two-year Treasury notes edged up to 0.20% from 0.16% on Tuesday.


How does this Fed stimulus plan differ from previous plans?

To buy the majority of its Treasury and mortgage bonds in the last few years, the Fed in effect printed new money. This time it isn’t doing that. “This is moving around the securities they already own,” Lederer said.

The Fed has been sensitive to criticism that by pumping vast new sums into the financial system to buy bonds it could eventually stoke inflation. By shifting existing assets into longer-term bonds the Fed may hope to avoid fueling more inflation concerns.

What is likely to happen to mortgage rates, in particular?

They should fall. Besides buying more longer-term Treasuries, the central bank threw the mortgage market another bone: The Fed said it would use the proceeds from maturing securities in its $885-billion mortgage-backed-bond portfolio to buy more of the same.

Until now, the Fed has been using those proceeds to buy Treasury bonds.

The shift back to mortgage bonds could bring $20 billion or more a month of Fed buying power into that market, said Walter Schmidt, a bond market analyst at FTN Financial in Chicago.

The average 30-year home loan rate in Freddie Mac’s weekly survey was a record low 4.09% last week, down from 4.60% in early July. The 4% level is a psychological barrier for the market, but “I think we can breach that” soon, Schmidt said.


How low mortgage rates will go will depend on how low Treasury bond yields go. Ironically, though the Fed is trying to boost the economy by pulling longer-term bond yields down further, investors are more likely to join the new rush into bonds if they believe the economy will get worse before it gets better.

How does the Fed know that lower long-term rates will help the economy?

It doesn’t. Rates already are very low, yet the economy has weakened significantly this year. Also, by pushing long-term rates lower the Fed will be helping borrowers that already have easy access to cheap money.

Major companies, for example, may be able to sell new bonds at low yields to refinance older debt. Yet lower mortgage rates won’t help homeowners whose mortgages are worth more than their homes. Without equity, they won’t be able to refinance.

Another risk: By encouraging investors to buy bonds, the Fed’s move could backfire by driving more investors out of stocks and into bonds. On Wednesday the stock market suffered its biggest drop in a month, with the Dow industrials tumbling 283 points to 11,124.84 — a reaction the Fed probably didn’t want to see, analysts said.

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