Fed's mysterious policy: How will we know if it's working?

WASHINGTON — The Federal Reserve's bold but mysterious plan to purchase $600 billion in long-term government bonds through June will be under the microscope in 2011 even if it works, in part because determining that is anything but simple.

The bond-buying plan is an unparalleled effort to spark the economy. It's called quantitative easing. It's intended to lower long-term lending rates. It's controversial because critics worry it might lead to inflation that's hard to quell.

Ironically, the controversy about inflation itself may have been much of what Fed Chairman Ben Bernanke was after in the first place, although he's unlikely to say so publicly.

What Bernanke was trying to do, in part, with quantitative easing was to attack the threat of deflation — a decline in prices across the economy.

By sparking inflation fears, investor expectations shifted from worry that prices would fall into a downward spiral, a specter that can drive investors and consumers to postpone spending as they await lower prices, and thus depress economic growth. Instead, inflation is now seen as the bigger threat, though it has yet to appear.

The distinction is important because inflation, or a rise of prices across the economy, can happen only in an environment of economic growth. Thus a good bit of what the Fed tried to do with its second round of quantitative easing, now dubbed QE2, amounted to psychological warfare on investors and their expectations.

"QE2 is preventing the downside," said John Silvia, the chief economist for Wells Fargo Securities in Charlotte, N.C. "I think that as I read the commentary, and the presentations by Chairman Bernanke, I kind of get the impression that we're buying insurance against deflation. When you look at the process, the challenge you see is that a lot of financial institutions, and some consumers, have cash and are not putting it to work."

Through QE2, the Fed is trying to push investors into taking risks again. Many risk-averse investors have sought the safety of U.S. government bonds, so Bernanke is trying to make that less attractive by pushing up the prices of alternative assets, such as stocks. By purchasing longer-term bonds, the Fed helps lower the interest rate the bonds pay, which makes stocks and corporate bonds more attractive.

The Fed's hope is that increased investment in stocks and corporate debt will generate a psychological boost that spills over into the broader economy, increasing spending and confidence. Mainstream economists think that QE2 might add half a percentage point of growth to the U.S. economy in 2011.

The Fed may have achieved much of that goal with its Nov. 3 announcement of QE2. The stock market went on a tear, and stocks are on course to finish 2010 with strong gains. Market projections for 2011 are even more upbeat.

Don't expect the Fed to run any victory laps, however. It has to maintain a poker face while it purchases about $75 billion a month in bonds.

"Fundamental to QE2 is that it's hard to communicate that what you really do want is inflation. You do want assets to go up in price. That's why they have had a hard time explaining what they're doing," said Vincent Reinhart, a former top economist at the Fed and now a researcher at the conservative American Enterprise Institute.

In early December, there was talk that QE2 wasn't working because the so-called long bond, the 30-year government bond, was paying higher interest rates to investors — the opposite of QE2's stated aim. Many mortgage rates are pegged to the long bond, so mortgage rates were rising. All of this raised a question: Has QE2 really worked?

"I think to some extent it has," said Donald Kohn, until recently the Fed's vice chairman.

The Fed will get blame for failure, but not necessarily credit for success, since Obama's tax-cut deal includes stimulus measures that politicians will take credit for if they work, including a payroll-tax holiday and business-investment incentives.

"I think in the end that will make it difficult to interpret," Reinhart said. "If the more-upbeat forecasts are right ... fiscal policy will get the credit."

However if the economy remains sluggish, the Fed could find itself on the defensive for a policy that didn't deliver.