Fed's Bond Buy Signals Crisis

Stocks are rallying, bonds are soaring, and your mortgage rate could fall again now that the Federal Reserve has agreed to take on billions worth of new Treasuries and other securities to support the ailing economy. 

Don't be fooled: The Fed's decision is a reason to worry.

The decision today to buy $300 billion worth of long-term Treasuries over the next six months and expand existing lending programs by another $750 billion is actually a little scary. Precisely this sort of action was long considered a last-resort arrow in the Fed's quiver. But as the Fed said in its statement, the economy has continued to contract since January. With interest rates close to zero and available options dwindling, the Fed's move simply shows central bankers think the crisis is continuing.

As it has all along, the Fed has said it will act as needed to head off this recession. The question is, are we now finally approaching the point where as-needed becomes if-possible? With this move, the Fed's balance sheet is likely to pass the $2 trillion mark, and at some point the ability of the Fed to pour additional stimulus into the economy will run out.

Markets like this commitment by the Fed to bring down borrowing rates quickly and decisively. The bond market surged, with 10-year Treasuries climbing and yields sinking below 2.6 percent from around 3 percent on Tuesday. As Nigel Gault at IHS Global Insight put it, "The good news is that the Fed is firing all its weapons at the recession. The bad news is that the recession is severe enough that all weapons are needed."

The resulting faith-based rally could indeed mean we're nearing a moment of truth where the crisis turns a corner and monetary and fiscal efforts finally pay off. That should focus investors and regulators on making sure the plans in place work as advertised -- another reason to step back from today's grandstanding over AIG bonuses and calling for Treasury Secretary Tim Geithner's head. The systemic problems in the banking system and the economy still have to be fixed, and the longer the wait (on the TALF, on pricing bad assets, on forming a working public-private partnership to get lending flowing) the worse off we'll all be.

Further out, we could look back and see this as the point where the Fed drew a line in the sand in its efforts to reverse the effects of the credit crisis. (What comes later, including the threat of inflation and a weaker dollar from the Fed's unprecedented borrowing, are worth a mention too). Also, part of the reason for the buying may be the fact that other key customers for American debt (i.e. the Chinese) are losing interest, as Brad Setser points out today.

In all, investors looking for a sustained equity rally could be disappointed. The Fed's actions may be correct, but that doesn't mean they should be comforting. Doing everything possible to put out a fire only matters if the fire goes out.

The Fed's statement is here.