The Fed gets unconventional

The Federal Open Market Committee has decided to used "Quantitative Easing" to inject cash into the economy.

The Federal Open Market Committee has decided to used "Quantitative Easing" to inject cash into the economy.

On Wednesday, the Federal Open Market Committee announced that it would be getting into a new game: quantitative easing, aka unconventional monetary policy.

Usually, when the Fed wants to get more money flowing in the US economy, it targets a lower short term interest rate (aka the fed-funds rate) and then sells or buys short term bonds to get there. (Learned this from Yglesias). Since January, the Fed has “set” the short term interest rate between 0% and .25%. So it can’t really use selling and buying of short term bonds to get that short term rate any lower, and further encourage lending by banks to people who want capital.

Despite the slightly encouraging words recently uttered by Obama, Summers, and Bernancke himself, the FOMC (the people who decide what the “Fed” is going to do) apparently still think that the economy is not going to start getting better by itself (or with the assist of the Fed’s previous moves, the TARP, the stimulus, etc.), and that they needed to take some drastic new actions. Quantitative easing involves using monetary policy controls outside of the traditional short term interest rate manipulation as discussed above. Specifically, the Fed announced that it will be buying up to $300bn of long-term US Treasury Bonds and an additional $750bn of mortgage-backed securities. These moves intend to lower long-term interest rates and home mortgage interest rates, respectively. The purchase of long-term US Treasuries causes the long-term Treasury interest rate to fall, thereby encouraging investors to put their money into the more lucrative private sector instead of the newly cheapo US government. Purchase of mortgage-backed securties similarly allows businesses in the mortgage biz to grant mortgages at a lower rate, which will allow struggling homeowners to refinance mortgages (and save themselves money to be spent elsewhere in the economy) and perhaps even encourage people to start buying houses again (which is important, because houses are really expensive). Hopefully that simplifies things a little – I know I have been pretty confused for the last few hours about this – and feel free to drop some knowledge if you got it.

As of midnight on Thursday morning, the Fed’s moves seem to have succeeded in lowering long term rates. The US long-term Treasury rate dropped from 5% on Tuesday

I think this should actually be the 10-year yield. Take that New York Times.

This graph shows the 30-year Treasury Bond interest rate. The 10-year rate fell from 3% on Tuesday to 2.53% by early Thursday morning.

to 2.53%, and most economists are confident that the long term mortgage rates will soon follow, possibly dropping as low as 4.5%. The hope, again, is that all of this cash appearing in the economy will get people buying, investing, and lending from/to/in each other, which is necessary for the economy to get going again.

Nobody can deny that the lending and investment is way more sluggish than it needs to be, so lowering interest rates is a good call. But when the Fed suddenly pours a ton of cash into the economy, there is a definite risk of inflation. Many experts don’t really think that this is a huge problem at the moment, and even that deflation may be more of worry, but the Washington Post reminds us that

the new purchases come with risks. They will balloon the value of the assets the Fed holds by about 50 percent, to more than $3 trillion. That could make it tricky for the central bank to draw that money out of the system once the economy starts to recover. The Fed would probably find it difficult to sell such massive volumes of assets, and if it doesn’t handle the task adeptly, the nation could face high inflation because too much money would be in circulation.

For the most part, however, economists (and the markets) seem pretty encouraged by the news. The WSJ’s Real Time Economics blog has a good roundup (I’ve excerpted slightly):

  • The point here is to drive new marginal capital flows out of Treasurys, by making them relatively unattractive, and into riskier assets. We aren’t sure $300 billion is enough, but this is a good start. –Ian Shepherdson, High Frequency Economics
  • Mortgage refinancing activity is likely to be quite strong in the coming weeks. –Nomura Global Economics
  • The Fed’s announcement signals a clear intent to continue to drive mortgage rates lower and we expect them to meet this objective. This could represent a powerful source of stimulus for the household sector of the economy. In 2008, the average mortgage rate on the outstanding stock of loans was about 6.50%. So, if the Fed brings 30-yr fixed rate mortgages down to 4.50% and all homeowners are able refi, the aggregate permanent cash flow savings would be on the order of $200 billion per year. –David Greenlaw, Morgan Stanley
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