Sense on Cents

The Federal Reserve has ZERO room to maneuver on its interest rate policy given the fact that its interest rate tool, the Fed Funds Rate, is currently set at 0-.25%. Could that rate be set at a negative level? Well, let’s just say that it has never happened with any central bank in the world. With no more arrows left in its interest rate quiver, what is a Federal Reserve to do to manage an economy? Let’s enter the world of “quantitative easing.”

Quantitative easing by any central bank is a policy in which that bank grows its balance sheet to purchase assets (government bonds, mortgage securities, government agency debentures, etc). The purpose of purchasing these assets is to drive the prices for these assets higher which in turn brings the interest rates on these assets lower (bond prices and interest rates on those bonds have an inverse relationship). The hope the Federal Reserve holds is that in bringing rates down (government rates and mortgage rates dropped by .3% to .5% yesterday) consumer and institutional demand for money will go higher and spur the economy in the process.

Wow! This sounds fairly easy. Why hasn’t the Fed utilized quantitative easing more aggressively prior to this? Well, the Fed already has employed a measure of quantitative easing starting late last year. The Fed purchased billions of the aforementioned securities. What happened? Did interest rates on these securities come down? Initially they did and then over the last few months they have moved higher. Why? Well, the demand employed by the Fed was offset by a lack of demand for these securities by foreign entities and domestic buyers. Was demand for credit by consumers and institutions sparked? Not really. Consumers and institutions remain very much in a delevering (paying down debt) mode as opposed to increasing debt obligations.

Should we expect a greater impact with this round of quantitative easing? Only time will tell.

If quantitative easing can move interest rates and equity markets by an order of magnitude of 2-4%, why not use more of this approach? Are there costs? Could quantitative easing be the magic bullet to save our economy? Is this the ultimate “money for nothing?”

In layman’s terms, I view quantitative easing as the equivalent of getting your room, meals, and drinks comped. However, every investor knows that for every perceived benefit there is a very real and actual cost. What are the costs of quantitative easing?

This policy will, in the future, massively grow the money supply in the economy. As the money supply grows, the value of that currency – that being our U.S. dollar – declines. The devaluation of our dollar is inflationary, but also a means to promote our exports. Make no mistake, the Fed and Treasury fully appreciate the risk of inflation but are willing to take that risk at this point.

The markets overnight have already reflected the fear of inflation and a lower dollar. The WSJ reports, Fed’s Move Sends Dollar Lower . Additionally, Oil Prices Jump on Weak Dollar

Welcome to Vegas!!

LD

This entry was posted on Thursday, March 19th, 2009 at 9:07 AM and is filed under Current Affairs, Economic Stimulus, Economy, Equity Markets, Risk, Stimulus Plan, Wall Street. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.