msnbc.com news services
updated 10/15/2010 6:26:07 PM ET 2010-10-15T22:26:07

Federal Reserve Chairman Ben Bernanke is balancing a short-term fix for the economy with a long-term gamble: His plan to buy Treasury bonds to fight high unemployment and super-low inflation now could ignite inflation later.

Major Market Indices

But Bernanke is signaling that doing nothing would pose the biggest risk of all.

The Fed chief on Friday made his strongest case yet for injecting billions more dollars into the economy. Purchasing the bonds could further drive down rates on mortgages, corporate debt and other loans.

Lower rates could lead people and companies to borrow and spend. And higher spending might help ease unemployment and invigorate the economy.

  1. More must-see stories
    1. The Hartford Courant, Political
      Wild Wall St.

      Has the market volatility got you nervous? These cartoons may give you a little comic relief.

    2. Cyber-thieves create fake Kelley Blue Book site
    3. US says Reebok toning shoes don't really
    4. Can you live on $9 an hour? Play the game

The Treasury purchases would have another aim, too: to dispel any notion that consumer prices will stay flat and might even fall. In his speech Friday in Boston, Bernanke indicated that Fed policymakers favor raising inflation, which has all but vanished.

And more inflation could help the economy. How?

Companies would feel more inclined to increase prices. And shoppers who thought prices were headed up would be more likely to buy now rather than wait. Their higher spending could embolden employers to step up hiring. It would also help lift inflation.

But overhanging the Fed's plan is the risk that it would trigger runaway inflation months or years from now.

Once investors began to fear approaching inflation, they would demand higher rates on bonds. Banks, too, would raise loan rates to compensate for the higher inflation they expect. Workers would demand higher pay. Any strength the economy had managed to gather could dissolve.

Bernanke made clear he's mindful of the gamble. But he also indicated he feels that short-term needs take priority.

"There would appear — all else being equal — to be a case for further action," Bernanke said, building on the case he first laid out in an August speech in Jackson Hole, Wyo.

The Fed is returning to unorthodox steps like buying government bonds to aid the economy because it's already sliced its key interest rate to a record low near zero.

Some economists say the Treasury purchases might not work because interest rates already are so low that the benefit of driving them lower would be scant. And lower rates won't help if businesses and individuals can't afford to borrow, don't want to borrow or cannot qualify for loans.

To buy Treasury debt, the Fed in effect prints money. As the Fed snaps up Treasury bonds, the rates on those bonds will fall. Rates on mortgages, corporate debt and other loans pegged to Treasury securities will drop, too.

It comes down to supply and demand: Higher demand for bonds lowers their rates, or yields. And it drives up their prices.

Fed policymakers are expected to announce their Treasury buying program at their next meeting, Nov. 2-3. Bernanke indicated that a big issue remains unresolved: How big should the Treasury purchases be and how fast should they be carried out?

Story: Consumer prices rise in Sept. due to energy

During the recession, the Fed launched a $1.7 trillion program of buying mortgage securities and government debt. That effort was credited with forcing down mortgages rates, which helped prop up the housing market. The Fed's new program is likely to be much smaller. One Fed official has suggested a $500 billion program. Another has hinted it be $100 billion or less.

Still, even purchases of that size risk feeding inflation and, most dangerously, setting off a wave of speculative buying that could inflate the prices of stocks, bonds or other assets. Low mortgage rates after the 2001 recession were blamed for the housing bubble that burst and led to a severe recession starting in late 2007.

Yet another worry: The extra dollars flowing from the Fed's Treasury purchases might send the dollar's falling value even lower and incite a panic. If China and other investors dumped dollar-denominated assets, for instance, interest rates would soar.

And if tougher economic conditions forced the Treasury to sell more bonds to raise money, the national debt, already at $14 trillion, would swell.

The economy is growing at a pace "less vigorous than we would like," Bernanke acknowledged. And inflation is running too low for a healthy economy, he said.

Unemployment, now at 9.6 percent, has been stuck near double digits for more than a year. Bernanke indicated concern that economic growth will remain lackluster and that unemployment will decline only slowly next year. High unemployment would keep consumers cautious in their spending, Bernanke said.

Because the economy is still so sluggish, "the risk of deflation is higher than desirable," Bernanke said. Deflation is a widespread drop in prices, wages and the values of stocks and homes.

Deflation is dangerous for individuals, companies and the economy overall. Workers suffer pay cuts. Corporate profits decline. Stock values fall. People, businesses and the government find it costlier to pare debt. Foreclosures and bankruptcies rise.

And people spend less, convinced that prices will fall even further if they just wait. That trend is already evident in the housing market. Many would-be buyers are idling on the sidelines, expecting home prices to keep dropping.

Read Bernanke’s speech in full on the Federal Reserve’s Web site.

The Associated Press and Reuters contributed to this report.

Video: Fed weighing risks of bond-buying program

Discuss:

Discussion comments

,

Most active discussions

  1. votes comments
  2. votes comments
  3. votes comments
  4. votes comments

Data: Latest rates in the US

Home equity rates View rates in your area
Home equity type Today +/- Chart
$30K HELOC FICO 4.32%
$30K home equity loan FICO 5.00%
$75K home equity loan FICO 4.36%
Credit card rates View more rates
Card type Today +/- Last Week
Low Interest Cards 11.09%
11.09%
Cash Back Cards 16.42%
16.42%
Rewards Cards 16.04%
16.04%
Source: Bankrate.com