Fed lays out another $1 trillion

WASHINGTON —  Escalating the government’s already aggressive effort to revive the struggling economy, the Federal Reserve said Wednesday that it would spend an additional $1 trillion to bring down interest rates on home mortgages and other business and consumer loans.

The surprise news that the central bank would more than double its planned purchases of mortgage bonds and also start buying large quantities of Treasury bonds had an immediate effect on the financial markets. The Dow industrials posted their sixth gain in seven trading days, while long-term interest rates plummeted -- exactly the reaction the Fed wanted.

The Fed’s latest move -- coupled with an unprecedented panoply of previous steps by the government to fix the financial crisis and stimulate spending -- makes it more likely that the country’s 15-month-old recession will be over by the end of this year, with economic growth resuming early in 2010, economists said.

“They are trying to fire absolutely every weapon they can,” said Nigel Gault, chief U.S. economist at forecasters IHS-Global Insight in Lexington, Mass. “It improves the odds that we’ll bottom out in the second half of the year.”

The central bank’s main tool to combat a recession, lowering a key short-term interest rate, was no longer an option because that rate had already been slashed to practically zero.

So instead the Fed intends to buy an additional $750 billion in mortgage-backed bonds issued by Fannie Mae and Freddie Mac, more than doubling its planned purchases this year of those securities. And, in a rare move, it also plans to buy $300 billion of long-term U.S. Treasuries.

“The Fed has been looking for a new way to make a big headline announcement effect on the markets, and they have found it,” said Chris Rupkey, an economist at Bank of Tokyo-Mitsubishi.

But the action also increases the risk that inflation, dormant for the last year, could spring back to unwelcome heights. That danger sent the value of the dollar down against other currencies and boosted the market price of gold by about $50 an ounce, putting it back above $900.

The prospect of recovery, however, cheered the stock market, which had been down for the day before the Fed’s announcement. The Dow Jones industrial average closed up 90.88 points, or 1.2%, at 7,486.58. The broader Standard & Poor’s 500 stock index surged 2.1%.

Since hitting 12-year lows last week, the Dow has jumped 14% and the S&P; is up 17%.

In the bond market, the yield on 10-year Treasury note -- considered a benchmark for home loan rates -- tumbled about half of a percentage point, suggesting that mortgage rates also could fall that much.

The Mortgage Bankers’ Assn. said Wednesday that the average 30-year loan rate fell to 4.89% last week, down from 4.96% the week before.

David M. Jones, a former Fed economist now with DMJ Advisors in Denver, said mortgage rates could drop a full point.

“If you bring the interest rate down that much, we’ll have a huge amount of refinancings,” he said.

“I’ve never known when the Fed has taken a move this powerful in easing monetary policy,” he added.

Lower home-loan costs could set off a series of beneficial effects. Smaller monthly payments for homeowners who refinance could stimulate consumer spending. More-affordable mortgages also would encourage people to buy homes, and allow more people to qualify for a loan. That would help stabilize the housing market, which is considered the main source of the problems confronting the financial system and the economy.

If housing does stabilize, the wave of huge mortgage-related losses recorded by banks could begin to dry up. In the meantime, troubled banks could benefit from a surge in revenue by issuing new mortgages.

“Bottom line, these actions by the Fed today certainly increase the chances of a housing bottom sometime this year,” said Scott A. Anderson, chief economist at Wells Fargo Economics in Minneapolis.

Similarly, the Fed hopes, interest rates paid by companies and consumers on a variety of loans would fall, rescuing some firms and households from financial distress and making it easier for many to boost their spending.

Of course, there’s no guarantee all this will occur.

Mortgage rates may not fall that quickly because lenders, whose numbers have shrunk significantly since the housing crisis began, are already swamped with applications for loan refinancings and modifications, said Guy Cecala, editor of Inside Mortgage Finance, a trade publication.

“If they have all the business they can handle, what’s their incentive to lower their rates?” he said.

Indeed, although the Fed has kept the rates it charges banks near zero since December, interest rates for consumers and businesses have remained stubbornly high because banks are cautious about issuing new loans during a recession.

“We’re not in a credit crunch because of an inability to provide credit. It’s because of an unwillingness to create credit,” said Joel Naroff, president of Naroff Economic Advisors in Holland, Pa.

The economy’s continued deterioration forced policymakers to reach further into their economic medicine chest.

“Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending,” the Fed’s rate-setting committee said in a statement. “Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession.”

In its statement, the Fed’s rate-setting panel expressed cautious optimism.

“Although the near-term economic outlook is weak,” the panel said, “the committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth.”

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Times staff writer Tom Petruno contributed to this report.