What the Fed should really be buying

NEW YORK (CNNMoney.com) -- Maybe it's time for the Fed to think outside the box.

Wall Street is counting on the Federal Reserve to announce purchases of long-term government bonds on Wednesday, a policy known as quantitative easing. But some Fed watchers think that buying up more plain-vanilla bonds won't work, and recommend more unorthodox strategies.

"I think the Fed wants to be creative, and I wouldn't be surprised if they buy assets other than just Treasuries," said Kenneth Naehu, managing director and head of fixed income at Bel Air Investment Advisors.

While current law restricts the Fed to buying low-risk assets like Treasury bonds, that's not necessarily set in stone, said Paul Ashworth, U.S. economist with Capital Economics.

In November 2008 for example, the Fed invoked a provision of the Federal Reserve Act that allows it more wiggle room under "unusual and exigent circumstances," and created the Term Asset-Backed Securities Loan Facility as a way to buy student, auto and credit card debt.

"In theory, there's nothing the Fed can't buy," Ashworth said.

Here are a few alternative suggestions:

Jump start the housing market. In addition to U.S. Treasuries, the Fed could also buy debt issued by government agencies like mortgage issuers Fannie Mae and Freddie Mac, said Stuart Hoffman, chief economist with PNC Financial Services.

The Fed's first round of quantitative easing included mortgages backed by Fannie and Freddie as an attempt to prop up the flailing housing market.

The proponents of quantitative easing argue that getting more money into the mortgage market would drive interest rates further down and could help homeowners refinance their mortgages and avoid more foreclosures.

As another method to support the housing market, the Fed could also consider buying real estate investment trusts, or REITs, said Ashworth. REITs sell like stock on the major exchanges and invest in real estate directly.

Help states and local governments. Mortgage rates are already at historic lows, and that's not spurring consumers to buy homes or driving banks to lend more, said Mark Vitner, senior economist with Wells Fargo. Instead, uncertainty about the job market and the economy is holding back spending.

"I don't know that knocking half a point off mortgage rates is going to be the critical thing to spur a recovery in housing," he said. "The Fed has to be looking at doing something different, and looking for ways to bring liquidity to parts of the market that didn't benefit from the first round of quantitative easing."

Instead, Vitner proposes that the Fed consider buying bonds issued by state and city governments, as a way to stave off a potential Greek-like debt crisis in local governments.

The Fed has not bought state or local government debt since 1933, and it's currently restricted from buying those bonds with longer than a 6-month maturity outstanding.

It's a long shot policy Vitner, says, but still, a creative solution that would help municipalities refinance their debt or issue new debt at a lower cost.

Spur private sector spending. Roger Farmer, head of economics at UCLA, proposes the Fed buy broad-based indexed stocks, and no Treasuries, as a way to boost confidence and spending in the private sector.

This strategy could calm stock market volatility and encourage individual investors to put their money back into financial markets, he said. Funneling more money into the private sector would hopefully spur businesses to start hiring and spending again.

And once the economy shows some improvement, stocks offer a better exit strategy than Treasuries, Farmer said.

Help small businesses. Buying long-term Treasuries would have a very limited effect when interest rates are already so low, said Catherine Mann, a finance professor at Brandeis University and former Fed economist

Buying stocks might not be effective either, Mann said. Why would central bankers funnel more money to big corporations, she asked, when those companies are already sitting on $1 trillion in reserves?

Instead, Mann suggests the Fed fund loans backed by the Small Business Administration. They're relatively low risk because they're guaranteed by a federal agency, and they could help jumpstart the small and medium-sized businesses that suffered most from the credit crunch, she said.

Raise inflation gradually. Instead of looking to alternative assets, many economists think the Fed will buy a mix of Treasuries ranging from 2-year to 10-year maturities, but rolled out gradually, instead of in one lump-sum purchase.

Zach Pandl, an economist with global investment banking firm Nomura, recommends starting with a $200 billion purchase and accumulating to $600 billion sometime early next year.

While it's unrealistic to think any type of quantitative easing would guarantee a rapid recovery, Pandl said, an incremental program would hopefully raise inflation a bit and help the economy avoid a second recession.

In anticipation of a big announcement from the Federal Reserve on Wednesday, mainstream estimates put the overall total for quantitative easing anywhere between $500 billion and $1 trillion.