Fed Lacks Consensus on Treasury Purchases Even as Yields Climb

By Scott Lanman and Craig Torres

Feb. 9 (Bloomberg) -- Federal Reserve officials have failed to resolve an internal debate over whether to purchase long-term Treasuries, even as rising yields on the securities threaten to undermine the central bank’s objective of cutting borrowing costs for consumers and businesses.

Policy makers are instead focusing on a program to purchase $200 billion in consumer and small-business loans and on a plan to buy $600 billion in home-finance debt, according to people familiar with the deliberations.

Forgoing purchases of Treasuries may exacerbate a jump in borrowing costs for the government as federal debt managers seek to finance an unprecedented budget deficit. Benchmark 10-year note yields this week exceeded their level of Dec. 1, when Fed Chairman Ben S. Bernanke first talked about the option. That’s raised other borrowing costs, potentially delaying a recovery.

“The Fed will get a lot more bang for its buck by buying mortgages than buying Treasuries,” said John Ryding, founder and chief economist of RDQ Economics LLC in New York and a former Fed economist. “We were kind of a little surprised when the Fed wanted to go down this route” in comments starting in December, Ryding said.

Fed officials are seeking other ways to use monetary policy to ease credit after cutting the benchmark interest rate almost to zero, completing more than 5 percentage points of reductions since September 2007.

FOMC Meetings

The debate over buying Treasuries has now continued for two meetings of the Federal Open Market Committee. The potential acquisition of government debt to help finance a bank rescue doesn’t appear in the minutes of the December meeting.

The FOMC’s post-meeting statement on Jan. 28 signaled that not all participants are convinced. The panel “is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets,” the statement said.

That’s still a harder line than on Dec. 16, when policy makers said they were “evaluating the potential benefits of purchasing longer-term Treasury securities.” Bernanke said in a Jan. 13 speech that the FOMC will focus on the “potential” of the purchases “to improve conditions in private credit markets, such as mortgage markets.”

Fed Split

Richmond Fed President Jeffrey Lacker dissented from the Jan. 28 decision, highlighting a split between the Board of Governors and some Fed presidents on how to stem the credit crisis and revive economic growth. Lacker preferred to expand the money supply “by purchasing U.S. Treasury securities rather than through targeted credit programs,” the FOMC statement said.

Buying Treasuries would reduce yields on government debt, prompting a decline in rates on mortgages, corporate bonds and other types of borrowing, according to Lacker and some other policy makers.

Still, there’s no guarantee the purchases would work, given that cuts in the Fed’s main interest rate failed to pare costs for corporations and other borrowers. Also, money created by the central bank to buy the Treasuries may fuel inflation should the Fed fail to quickly unwind the purchases as the economy begins to rebound.

‘Higher’ Bar

“The bar is a lot higher than we thought,” said Brian Sack, vice president at Macroeconomic Advisers LLC, and a former section chief at the Fed Board. “The statement said they are going to employ all available tools and yet they are reluctant to use the tool that is most readily available.” The FOMC next meets March 17.

Rates on long-term Treasuries have climbed this year as investor hopes faded for a quick start to Fed purchases. The yield on the 30-year government bond was 3.70 percent on Feb. 6, compared with 2.68 percent on Dec. 31.

Costs for home loans are also rising. The average U.S. rate on a 30-year fixed mortgage increased to 5.25 percent last week from 5.10 percent the previous week, housing-finance provider Freddie Mac said on Feb. 5. In the week ended Jan. 23, mortgage applications in the U.S. slumped by the most in 16 years as refinancing plunged.

Fed purchases of Treasuries would sustain demand amid speculation China and other nations may curtail their holdings in U.S. debt, said Bill Gross, co-chief investment officer of Pacific Investment Management Co., the world’s biggest bond-fund manager.

China Investment

China is the largest investor in U.S. government securities, holding $681.9 billion of Treasuries.

“To the extent that the Chinese and others do not have the necessary funds, someone has to buy them,” Gross said in an interview with Bloomberg Television. “It is incumbent upon the Fed to step in. If they do, that will be a significant day in the bond market and the credit markets.”

Investors were disappointed when the Fed didn’t announce plans to buy long-term Treasuries in its Jan. 28 statement. The yield on 30-year Treasury securities rose 17 basis points to 3.41 percent that day. A basis point is 0.01 percentage point.

“What are they waiting for?” said Mark Spindel, who invests about $100 million as chief investment officer at Potomac River Capital in Washington. “I don’t understand this resistance from the Fed. Mortgage rates are now beginning to rise.”

Corporate Borrowing

One index shows the premium for corporate borrowing costs over 10-year Treasuries. While the spread has narrowed to 5.19 percentage points since reaching a high of 6.22 points on Dec. 16, it’s still more than triple the average spread of 1.66 percentage points in the year before the credit crisis started in August 2007.

As of Feb. 4, the Fed had bought $7.38 billion of mortgage- backed securities, out of $500 billion authorized, and $29.9 billion of debt issued by Fannie Mae, Freddie Mac and Federal Home Loan Banks, out of a possible $100 billion.

The Fed plans this month to announce a start date for the Term Asset-Backed Securities Lending Facility, or TALF, to prop up the market for student and auto loans, credit-card debt and small-business lending.

The Fed will release minutes of the Jan. 27-28 FOMC meeting on Feb. 18. Bernanke will testify before Congress on Feb. 10, give a speech on Feb. 18 and provide semiannual testimony on monetary policy to the Senate and House starting Feb. 24.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net; Craig Torres in Washington at ctorres3@bloomberg.net.