The Monetary Stimulus, Or Start the Printing Presses

The main policy setting committee of The Federal Reserve, the Federal Open Market Committee (FOMC) voted unanimously (10-0) today to employ the only monetary levers it has left to prop the US and global economy. The FOMC opted to pump an extra $1 trillion into the financial system by purchasing Treasury bonds and mortgage securities. From their press release, here is how the FOMC views the economy:

Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract.  Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending.  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.  Although the near-term economic outlook is weak, 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.

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued.  Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

In its announcement, the Federal Reserve is saying that the United States remains in a severe recession and listed a litany of our continuing woes, job losses, falling equity markets, lost housing wealth and declining exports as a result of the worldwide economic slowdown. The FOMC isn't worried about inflation, rather it continues to worry about declining asset prices.

Now here is what they have opted to do. It's a quantitative easing or a monetary stimulus:

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.  The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.  To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve's balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion.  Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.  The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets.  The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of evolving financial and economic developments.

The Fed has been out of the magic bullet of rate cuts with interest rates effectively at near zero for some time now, so this is its alternative, a monetary stimulus aimed at two faltering parts of the US economy, the US housing market and the US credit market. The decision by the Fed to buy government bonds and mortgage-related securities is designed to lower borrowing costs for home mortgages and other types of loans, thereby stimulating economic activity. To do this, the nation's central bank, effectively, will print more money to pay for the purchases.

I tend to agree with Nigel Gault of IHS Global Insight:

Like all of the measures announced by the Fed as the financial crisis and recession have deepened, today's measures are not a silver bullet. However, they are one more step in the right direction, and the accumulating force of monetary and fiscal stimulus being aimed at the recession increases confidence that the economy will bottom out in the second half of 2009 and that 2010 will see a resumption of growth.

This is a step in the right direction for now both fiscal and monetary policy are aligned on the course of greater spending. In short, it's a one two punch. My worry and where I disagree with Mr. Gault is the timing. The US economy may be in the throes of a structural adjustment that takes years to correct.

The FOMC's announcement signals a clear intent to continue to drive mortgage rates lower and to revive the economy by stimulating the moribund housing market. 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 200 basis points to 4.50% and all homeowners are able refinance, the aggregate permanent cash flow savings would be on the order of $200 billion per year according to David Greenlaw of Morgan Stanley.

The FOMC's decision is not without risk. The action makes the Fed a buyer of long-term government bonds rather than the short-term debt that it typically buys and sells to help control the money supply. Again to do so, it is resorting to printing money and ballooning its balance sheet. This will dilute the value of the dollar. In the near-term, the action will balloon the value of the assets the Federal Reserves holds by almost 50%, to more than $3 trillion. Longer-term that could make it difficult for the central bank to suck that money out of the system once the economy starts to recover. The concern among economists is the the exit strategy, that is that the Fed will find it difficult to sell such massive volumes of assets when the economy does begin to recover. The concern is that if the Fed doesn't handle the task adeptly, the nation could face a period of high inflation because too much money would be in circulation. And if we are in a structural adjustment, that is the nation's jobless rate will continue to rise, that combination of inflation and high employment is lethal to the electoral prospects of those in power when it does hit.

[Update] The dollar plunged against major currencies Wednesday after the Federal Reserve left a key interest rate at a record low and said it would buy up to $300 billion of long-term government bonds, a new step aimed at jolting the country out of recession. The 16-nation euro surged more than 4 cents to $1.3424 in late New York trading from $1.3005 the night before, while the British pound jumped to $1.4223 compared with $1.4026. The dollar bought 96.31 Japanese yen, down from 98.46 yen. More at Forbes. Also here is the full story in the New York Times.

Tags: FOMC, monetary policy, The Federal Reserve (all tags)



Structural downturn

You keep saying that you think we are in the midst of a structural shift that will take years to correct.

I have two questions:

a) Have you specifically laid out the case for this structural downturn?

b) What, if anything, can be done about such a downturn?

by bruh3 2009-03-18 07:33PM | 0 recs
Re: Structural downturn

Look at previous posts on the balance sheet recession. That is still my thinking. It should be noted that a quantitative easing was tried in Japan and it didn't work. Granted Japan's problem are slightly different that ours.

by Charles Lemos 2009-03-18 08:09PM | 0 recs
Re: Structural downturn

Okay. I read a few essays on what you mean and Koo's book regarding Japan.

It would seem to me we are choosing a more dangerous path regarding addressing the deflationary pressures because as you said it could lead to a period of quick and high inflationary pressures.

The irony is that I also read that there are more direct solutions such as nationalization that would address the problem.  Yet, for political reasons, this option will probably not happen. It  seems odd that they would take a chance like this when they know other options are available. That's assuming I understand the big picture.

by bruh3 2009-03-18 08:36PM | 0 recs
So when will mortgage rates come down?

It's not happening yet in what seem to me to be any significant way.  I would love to get my 6% mortgage down to 4 1/2%, just waiting.

by viperlmw 2009-03-19 07:32AM | 0 recs
Re: So when will mortgage rates come down?

some rates went down today (few i don't think its across the board yet, or a BIG drop) but its 12:25 EST now.

by sepulvedaj3 2009-03-19 08:29AM | 0 recs


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