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Fed considers Sterilized Bond Buying to boost economy

March 12, 2012

The Federal Reserve is considering a new type of bond-buying program designed boost the economy in the months ahead while curbing future inflation, according the Wall Street Journal, according myvoiceoflife blog.

Federal Reserve officials have used different types of bond-buying programs since 2008. All of them are aimed to drive down long-term interest rates to spur investment and spending by businesses and households. Now they’re exploring three different approaches, which are:

The Fed could use the method they used aggressively from 2008 into 2011, in which the Fed effectively printed money and used it to purchase Treasury securities and mortgage debt. The Fed has already acquired more than $2.3 trillion of securities in several rounds of purchases using this approach, widely known as “quantitative easing,” or QE.

They could reprise a program launched last year in which it is selling short-term Treasury securities and using the proceeds to buy long-term bonds. This $400 billion program, known as “Operation Twist,” allows the Fed to buy bonds without creating new money.

In the new novel approach, the Fed could print money to buy long-term bonds, but restrict how investors and banks use that money by employing new market tools they have designed to better manage cash sloshing around in the financial system. This is known as “sterilized” QE.

The Fed’s objective under any of these programs would be to reduce the holdings of long-term securities in the hands of investors and banks. The Fed believes that reducing the amount of long-term bonds in the hands of investors drives down long-term interest rates, encourages more risk-taking, and thus spurs spending and investment by households and businesses.

Under the third approach, the Fed would create new money as it buys long-term bonds. But then it would effectively lock up the money rather than letting it loose in the broader economy. The Fed would do this by borrowing the money back from investors for short periods—say, 28 days—in exchange for some low interest rate it would pay investors. The effect of this approach is the same as Operation Twist: The Fed would hold more long-term bonds and investors and banks would get more short-term holdings in exchange.

The third approach has some benefits the other options don’t have. Unlike Operation Twist, the size of the program wouldn’t be constrained by the Fed’s own holdings of short-term Treasuries.

Moreover, the program could be conducted with financial institutions other than banks, like money-market funds, increasing the Fed’s flexibility in managing reserves. The reverse-repo program was designed to include money-market funds and these institutions don’t participate directly with the Fed in other operations.

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