Will the Fed’s $600 billion plan be big enough to revive the economy?

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Let’s hope Ben is ordering the right kind of stimulus. (Jo Yong-Hak/REUTERS)

The Federal Reserve’s long awaited, much anticipated and plenty feared plan to revive the economy is here.

After two days of debate, Ben Bernanke and his fellow members of the US central bank’s policy committee voted to spend an additional $600 billion to buy long-term Treasury bonds over the next eight months. The Fed is already spending about $35 billion a month to keep an earlier announced mortgage bonding buying plan in place. So all told, the Fed is planning on pouring an addition $900 billion into the bond market in the next two months.

Why? Well, it’s called quantitative easing and here’s how it works: Lower interest rates are supposed to spur economic growth by encouraging companies to borrow and spend. And higher demand for bonds tends to make interest rates fall. So if the Fed steps in with big purchases of bonds it can drive down interest rates. The important piece here is that the Fed is buying long-term Treasury bonds. You see, we talk about the Fed having the power to set interest rates. But really the Fed can only set very-short-term interest rates. Extremely short. The U.S. central bank dictates the rate that it lends money to banks overnight. It has already set that rate to zero. Those very-short-term rates do tend to cause longer rates to fall, and they have, but not directly. So, for the second time since the financial crisis, the Fed is directly attacking long-term interest rates. The hope is that lower long-term interest rates will give the economy the boost that near zero short-term rates haven’t. (The recovery looks weak at best.) Unfortunately, the success of Bernanke’s plan is far from given. And the reason may be that much like many of the plans that have been announced over the past two years, it’s just not big enough. Here’s why:

In theory, long-term bond rates should do more to boost the economy than near zero short-term rates. The reason is that the things that companies do that really cause them to have to hire lots of people such as enter new markets or build new plants, are generally long-term commitments. It takes a few years for a new factory to start generating cash. So being able to borrow money at a low rate for a few months might not be enough of an incentive to get an executive to decide to expand. But if a company can lock in a low interest rate for say 5 or 10 years, then the chance that a new plant will be profitable before the company’s financing costs go up are more likely.

So will it work? It’s not clear. Surprisingly, interest rates on 10-year and 30-year bonds actually rose on Wednesday. In part, that’s because the Fed said that it would focus most of its buying on medium-term notes, such as 5-year to 7-year bonds. But it is also a sign that the plan may have the desired effect. An upward sloping yield curve, when short-term rates are lower than long-term rates, is a sign of a strong economy. So if the long end of the curve rose that means more people think the economy will end up stronger after Bernanke’s plan. If that wasn’t the case, the long-rates probably would have slumped as well.

The real question then is if the Fed’s plan is big enough to really make a dent in our severely wounded economy. And the answer may be no. Joseph Gagnon, who works for the Peterson Institute and is generally for the quantitative easing plan, has done the math and says that to lower the unemployment rate by 1% it generally takes $1 trillion in Fed purchases of long-term bonds. That’s why earlier this year, Gagnon was pushing for the Fed to announce $2 trillion in government purchases. He figured that along with the slow momentum of the economy $2 trillion in Fed bond purchases would bring down the unemployment rate to about 6.5% by the end of 2011. By Gagnon’s math, the Fed’s current plan will only lower unemployment by just over one half of a percent. Which means, again by his calculations, we will still have an unemployment rate of 8% by the end of next year. “It’s better than nothing,” says Gagnon. “But it won’t achieve the Fed’s goal.”

That’s why Gagnon suspects the Fed announced a smaller than is needed plan first and waited to see how the market reacted. But that’s a gamble, according to Gagnon. The longer it takes for the economy to recover the greater the chances that we will fall into deflation. Wait long enough and it’s Japan all over again. Let’s hope the Fed has bet correctly.