Will the Fed go long?

The Fed won't cut short-term rates at its next meeting, but look for long-term rates to drop if the central bank announces plans to buy Treasurys.

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By Chris Isidore, CNNMoney.com senior writer


NEW YORK (CNNMoney.com) -- The Chinese are getting nervous about buying U.S. Treasurys. Does that mean it's time for the Federal Reserve to start buying long-term notes?

The answer could come as soon as Wednesday, when the U.S. central bank concludes a two-day meeting. The Fed has said in its last couple of statements that it was prepared to buy long-term Treasurys as a way to try to further help the economy. But so far, it hasn't given any details about how much it would buy, or when it would start doing so.

The meeting comes in the wake of Friday's comments from Chinese Premier Wen Jiabao, who expressed concern that the more than $700 billion in Treasury debt his country holds is at risk of seeing its value fall due to rising budget deficits here.

"We have lent a massive amount of capital to the United States, and of course we are concerned about the security of our assets," said Wen at his annual news conference on Friday. "To speak truthfully, I do indeed have some worries."

If the Fed started buying 10-year Treasury notes, that wouldn't do anything to reduce risk tied to soaring U.S. budget deficits.

But it would provide some support for the value of the bonds, especially if the Chinese start to pull back on purchases as some economists are expecting.

So far, that hasn't happened. The Chinese Treasury holdings have increased by nearly $250 billion, or just over 50%, over the 12 months ending in December. And according to a report from the Treasury Department released Monday, China bought an additional $12.2 billion in Treasurys in January.

What's more, a large purchase by the Fed would help to lower the rates on longer-term Treasurys and other debt that is tied to the bond market, such as some corporate debt and mortgage loans. (Bond rates fall when prices rise.)

Former Fed Governor Lyle Gramley noted the Bank of England's announcement that it would buy about $100 billion in British government debt earlier this month was enough to lower long-term rates by a quarter-point to a half-point, even before the purchases started..

He believes the Fed is getting close to announcing its own Treasury purchase plans, especially since the central bank has already taken its key short-term interest rate, the federal funds rate, essentially to zero.

At its December meeting, the Fed floated the idea of buying Treasurys, stating it was "evaluating the potential benefits of purchasing longer-term Treasury securities."

By its January meeting, the Fed signaled it was getting closer to such a purchase, stating it was "prepared to purchase longer-term Treasury securities" if it became convinced that would be an effective way to get credit flowing through the economy once again.

But others think that long-term bond rates are not the economy's biggest problem. Even with the concerns voiced by the Chinese premier Friday, the yield on the 10-year rose only slightly, closing below 3%.

David Wyss, chief economist at Standard & Poor's, said the problem is that "people are scared to buy anything seen as having risks attached."

Wyss said the Fed's main focus now should be on new steps on getting battered banks to start lending more to businesses and consumers.

Still, if the Chinese and other major purchasers of U.S. Treasurys started to pull back on their purchases of the government notes, it would drive down the prices, and drive up the interest rates they pay, raising the cost of borrowing at a time when U.S. credit markets are still seized up.

And with the U.S. trade gap falling to the lowest level in six years in January in the latest reading Friday, there will be fewer incentives for foreign governments to buy Treasurys in the future. So that could force the Fed's hand at some point.

Still, there may be some resistance to buying Treasurys due to fears that such purchase would be sowing the seeds of inflation down the road and encouraging the U.S. government to go deeper into a debt hole.

But that may turn out to be a minor concern. Gramley said worrying about inflation now is like worrying about causing water damage when considering whether to spray a hose on a burning house. To top of page

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