Fed's next step may be small

NEW YORK -- The last time the Federal Reserve came up with a big plan to help the economy, it totaled $600 billion and touched off a 28 percent rally in the stock market.

But if the Fed takes any new steps, as many people expect, it won't look anything like that. Look for small ball, not a home run.

Investors are wondering what Fed chairman Ben Bernanke has up his sleeve. The economy is in danger of sliding back into recession, and the stock market has taken a hit this summer -- down 10 percent since Aug. 1.

And Operation Twist, as Fed-watchers are already calling it, in a nod to economic history, probably will help the economy and the stock market. Just not much.

At best, Goldman Sachs economists say, it may increase economic growth by 0.5 percentage points. That would help -- after all, the economy only grew at a 0.7 percent annual rate in the first half of 2011.

But it's a far cry from what it would take to get the economy back to full health. In decent years, the economy grows more than 3 percent.

Long-term interest rates, meanwhile, probably won't come down more than 0.2 percentage points after any new Fed action. What people pay for loans on houses and cars won't fall nearly as much.

And any bump for the stock market will probably be short.

Michael Hanson, a senior economist at Bank of America Merrill Lynch and a former Fed economist, said many investors tell him they think the Fed is cooking up a major initiative because of the carnage in the stock market.

"I think they're going to get disappointed," he said.

The Fed's options are limited, economists say, because it's already used most of its ammo.

Last fall, it launched a program to buy $600 billion in government bonds, with the goal of driving down long-term interest rates. That was the Fed's second round of what's known as quantitative easing -- nicknamed QE2. Stocks rallied 28 percent from August 2010, when Bernanke announced the program, to April.

A Fed study credited the program with cutting long-term rates by 0.2 percentage point. The yield on the 10-year Treasury, a benchmark for lending rates throughout the economy, has dropped more than 0.5 percentage point since QE2 was announced.

Doing it again, though, could raise worries among money managers about inflation. Critics say the Fed is essentially printing money when buying all those bonds and more cash in the economy will eventually lead to higher prices.

Just that fear can trigger inflation. If money managers are fretting about inflation, they're more like to buy oil, gold and other commodities as a hedge, driving up their prices and making the cost of gas, food and other things higher for everyday people.

Another worry is that a strong move by the Fed would be met with a stronger backlash from Congressional Republicans.

In any case, Hanson said, buying bonds is probably not the best medicine for the economy right now. Quantitative easing works best to stop prices from falling, he said, but overall consumer prices have risen 3.6 percent over the past year.

What the economy needs, many economists say, is another round of stimulus from the government. Bernanke, International Monetary Fund chief Christine Lagarde and other top economists have urged Congress to do just that.

Instead, Republicans in Congress have demanded spending cuts, and Democrats have gone along.

President Barack Obama proposed a $447 billion plan last week to spur job growth, a mix of tax cuts and new spending. Economists figure it could boost economic growth by 2 percentage points and add 2 million jobs.

Hanson and others doubt that Obama's entire proposal will make it through Congress, though.

The first hints of Operation Twist could come Sept. 21, at the end of the Fed's next policy meeting. Fed-watchers named it after a move by the Kennedy administration in 1961 to cut long-term rates without touching short-term rates. At the time, Chubby Checker's twist was the dance craze.

The Fed has outlined the basics steps: It would buy long-term Treasurys with cash raised from unloading Treasurys due in the next few years. Wall Street economists estimate the Fed could spend between $200 billion and $300 billion.

In theory, that should put pressure on long-term interest rates to fall even further and encourage people and businesses to spend more because borrowing money will be cheaper.

"It's a low-risk way to help the economy," said Thomas Simons, market economist at Jefferies.

But it's a low-risk effort that will probably yield low rewards. The interest rate on the 10-year Treasury note, a benchmark for loans across the economy, may not budge.

And besides, there's little evidence falling long-term interest rates are doing much good, Goldman's economists say.

Many economists and investors believe the Fed's move will give stocks a lift. When the Fed buys bonds, it drives up the prices, which makes stocks a more attractive investment by comparison.

That's a goal for the Fed because a rising stock market lifts confidence in the economy as a whole. The problem is that rates are already at historic lows -- and it hasn't stopped money managers from pouring money into Treasurys.

"The cost of borrowing isn't really the problem," said Paul Ashworth, chief U.S. economist at Capital Economics.

Before the financial crisis hit in 2008, lower borrowing costs usually encouraged companies to spend more and homeowners to refinance their mortgages. Not anymore.

Companies are sitting on $2.9 trillion in cash and afraid to hire people until demand picks up. And not enough people are taking advantage of low interest rates to turn around the housing market.

So should the Fed even try Operation Twist?

"It's the best tool they've got," Ashworth said. "I don't think it's going to hurt, but I don't think it's going to help much, either. Still, that doesn't mean they shouldn't try."