Updated with correction
Fixed-income money managers are cautiously hopeful that the Federal Reserve's unprecedented free-money and debt-purchase policy will help avert a deeper downturn for the credit markets and the economy.
At its Dec. 16 meeting, the U.S. central bank set a zero to 0.25% target range for the federal funds rate, down from 1%. With no weapons left on the interest rate front, Fed officials pledged to “employ all available tools ... open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level.” In short, the Fed is throwing the kitchen sink at the most widespread deflationary crisis since the Great Depression.
“We are in uncharted waters. No one can accuse the Fed of not trying to do enough. But no one knows whether it's really going to work or what the unintended consequences are,” Steven Bleiberg, president and chief investment officer of Legg Mason Global Asset Allocation LLC in New York.
“I'm hopeful it will help, but I can't say I have complete confidence this is going to work. You can't push on a string,” Mr. Bleiberg said, referring to economist John Maynard Keynes' expression illustrating how low interest rates cannot artificially generate demand for credit.
Indeed, the Bank of Japan's zero-rate policy of the 1990s failed to revive that country's economy after its asset-bubble burst. Having given up its ability to affect the economy through monetary policy, the Fed has turned itself into the buyer of last resort of various debt securities.
Through “quantitative easing,” the Fed is trying to address the main feature of the credit crisis: banks' reluctance to lend despite a massive capital injection from the government under Treasury's Troubled Asset Relief Program.
“Banks sit there like giant roach motels of the financial markets: capital goes in, but no loans come out,” said Robert Brusca, chief economist at New York consultancy FAO Economics. The dearth of bank lending has maintained market rates at historically wide spreads, the reason the Fed is buying securities that never belonged to its portfolio.
The Fed's bold new policy, which combines low rates and debt purchases, is raising questions about whether it will work or how the Fed eventually will unwind the huge amount of assets it bought as the credit markets' buyer of last resort.
“The Fed is supplying massive amount of liquidity in the face of the destruction of assets. Do I agree with the Fed? The answer is yes,” Scott Colyer, chief executive officer at Advisors Asset Management Inc., said in an interview. The Monument, Colo., firm, which specializes in fixed income, has $3 billion in assets under management.
“But I'm also very concerned because the Fed is multiplying its balance sheet by threefold or more. As the Fed creates additional currency, the credit of the U.S. could become very impaired as investors would not wish to hold it,” Mr. Colyer said. “Nobody has a playbook because history has not seen this type of event. Whether this is the correct response, we will see.”
The Fed's action already has drawn some positive reaction as long-term Treasury yields fell to record lows, driving mortgage rates on 30-year home loans to an all-time low of 5.19% Dec. 18, Federal Home Loan Mortgage Corp. data showed.
Some market watchers are concerned the Fed's efforts might help on the short term but create asset price distortions down the road, when the central bank decides to unwind its unusual holdings. The policy, which already is crushing the dollar, might also make it more difficult to finance the soaring budget deficit.
“They (Fed officials) are telling people they'll do whatever it takes so that credit availability and lending continues,” said James Grady, managing director at Deutsche Insurance Asset Management, New York, a division of Deutsche Bank AG, Frankfurt, that manages $135 billion.
