The Federal Reserve is experimenting with the money supply in an effort to bring a flagging U.S. economic recovery back on track. To keep interest rates that are already near zero down, the Fed is taking interest from its vast pool of mortgage-backed securities and getting U.S. Treasury notes and bonds. This practice, called monetary stimulus, or quantitative easing, injects cash to the public market. Debt will be monetized with an expanding money supply meaning interest rates will, in theory, go down. Since saving doesn’t help earn any money, companies and consumers have no reason to not to borrow and spend more.
Fed concerned with the economic outlook and bringing forth the monetary stimulus
The monetary stimulus was tried before and didn’t do anything to help the economy recover. Reuters reports the second round of quantitative easing, dubbed QE2, is the most essential monetary policy announcement for the Fed since it first revealed its intention to buy assets in late 2008. The QE2 announcement is doing opposite of what it was intended to do so far. Another round of monetary stimulus sends a signal the Fed is deeply worried about the fragile state of the economy. The announcement fueled a sense of doubt in markets. Stocks went down. Talk swirled of Japanese-style deflation, where no amount of monetary stimulus is enough to jump-start economic growth.
QE2 is a gamble for the Fed to take
The People’s Voice reports that this is a risky move the Fed is taking to announce a monetary stimulus. The Fed tried to help the housing crisis by buying up $ 1 trillion in securities from Fannie and Freddie which in turn made mortgage rates go super low. Fed officials wondered publicly how they were possible going to get rid of all these securities. Mortgage rates can be forced to go up because economic recovery isn’t really getting better. The Fed could be collecting principal and interest with this portfolio adding to billions. There is a lot of risk coming from monetizing debt. The housing market could very well weaken further and foreclosures could rise. If that were to happen to the fed, its portfolio would change to have billions of dollars of losses.
Getting into a liquidity trap
The monetary policy would be a fantastic move for the Fed if the economy were textbook. But Daniel Indiviglio, writing within the Atlantic, said that it relies on the assumption that demand will rise to meet supply. Companies sit on all of their money because they don’t think demand is going to expand in the near future although interest rates are low. Consumers are paying down their debt and saving for an uncertain economic future. This is why economists call it a liquidity trap. The economic recovery won’t be helped with lower interest rates if nobody is willing to borrow money.
Additional reading
Reuters
reuters.com/article/idUSN1123481920100811
The Peoples Voice
thepeoplesvoice.org/TPV3/Voices.php/2010/08/11/monetizing
Atlantic
theatlantic.com/business/archive/2010/08/will-the-feds-new-monetary-stimulus-help/61327/
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