WASHINGTON — The Federal Reserve on Thursday announced a series of bold and open-ended steps to stimulate the economy by making it cheaper for consumers and businesses to borrow and spend.
The Fed said it will spend $40 billion a month to buy mortgage bonds in its third round of "quantitative easing" for as long as it deems necessary to make home buying more affordable. It plans to keep short-term interest rates at record lows through mid 2015.
"The idea is to quicken the recovery," Fed Chairman Ben Bernanke said after a two-day meeting of the Fed's policy committee.
The Fed on Thursday also said it expects growth to be no stronger than 2 percent this year, down from its forecast of 2.4 percent in June. It still thinks the unemployment rate won't fall below 8 percent this year.
Here's a look at the Fed's main weapon in its quest to stimulate the economy, its third round of quantitative easing, or QE3:
What is quantitative easing?
In short, it's an unconventional monetary tool used by central banks to stimulate the economy. Normally, when there's a recession or the economy is limping along, the Federal Reserve will reduce short-term interest rates to spur more lending and spending. But right now, the Fed has cut interest rates as far as they can go and the economy is still struggling.
In quantitative easing, the Fed buys up assets like long-term Treasury bonds or mortgage-backed securities from commercial banks and other institutions. This pumps money into the U.S. economy and reduces long-term interest rates further. When long-term interest rates go down, in theory, investors have more incentive to spend their money.
Hasn't the Fed already tried quantitative easing?
Yes, twice. In late November 2008, after the financial crisis hit, the Fed started buying up mortgage-backed securities and Treasury bills to boost the economy. By June 2010, the bank had bought about $2.1 trillion worth of assets.
At this point, the Fed halted its actions, figuring that it had done enough. But when the economy started weakening that summer, Bernanke resumed the program in August 2010, buying up another $600 billion in assets in order to maintain the Fed's balance sheet. The second round was known as "QE2."
Did QE1 and QE2 actually boost the U.S. economy?
Academics have been churning out plenty of research on this question. The first round of quantitative easing appeared to be effective in preventing the economy from sinking into a giant depression. Economists say this was because everyone realized the Fed would do whatever it takes to avoid deflation. It was essentially a giant confidence boost. But the effects seemed to dwindle as the years went by. Experts are much more divided on how much QE2 has helped.
How does quantitative easing help the economy?
In his testimony to Congress in June, Bernanke explained why QE3 might bolster the economy. It would reduce the cost of borrowing money for corporations, bring down mortgage rates even further and potentially boost the stock market, increasing wealth effects for consumers to spur more spending.
Not everyone's convinced, though. In early September, Michael Woodford, a pre-eminent monetary theorist at Columbia University, released a long paper arguing that more quantitative easing was likely to be ineffective — because Bernanke is acting too sporadically. The Fed will buy up $600 billion worth of assets, hoping for a jolt, but people in the economy have no clear sense of what Bernanke's goals are.
Is there a way to make QE3 work better?
The Fed did two things to try to improve QE3. First, the central bank will keep short-term interest rates low until mid 2015. Second, it will buy up $85 billion worth of assets each month between now and the end of the year. But, unlike QE1 or QE2, this new round of purchases will be more open-ended.
The purchases will continue until morale improves. What's more, the Fed noted that it will continue its policy of easy money "for a considerable time after the economic recovery strengthens."
In essence, Bernanke is now taking Woodford's advice — or at least part of it.