The tool of choice for central banks to help an ailing economy has traditionally been to bring down short-term interest rates. The Federal Reserve is no exception. But having already pursued that approach aggressively, and seemingly exhausted it by driving the overnight interbank rate down to nearly zero, the question now at hand is whether the Fed has any more weapons in its arsenal.
The Fed's latest strategy has been to focus on the concept of quantitative easing, which simply means buying various types of (mostly) fixed-income securities to help maintain lower interest rates across the entire maturity spectrum, not just short-term ones. In fact, one of the main tactics that the Fed has been considering is to buy long-term Treasury securities to prevent a rise in such yields, a development that, if allowed to happen, would put up another hurdle on the road to any economic recovery later this year.
This approach would be a novel one. Attempting to manipulate long-term rates was never part of the Fed's repertoire of options in the past, other than an indirect, benign effect that a credible anti-inflation monetary policy would have on the overall level of such rates. But, then again, these are not exactly normal times, and unprecedented measures are not only welcomed but also desperately needed.
A key underlying motivation for the Fed's interest in a program of buying long-term Treasuries is the massive amount of supply in the period ahead. The Treasury's borrowing needs are likely to more than triple in the current fiscal year from the previous one, as the budget deficit is headed for the range of $1.5 trillion to $2 trillion. This raises the risk of causing indigestion in domestic credit markets, increasing long-term yields from their current exceptionally low levels. In short, this would raise mortgage rates, the last thing the housing market needs at this point.
If the Fed does start buying long-term Treasuries, what are its chances of success? There is a crosscurrent of headwinds and tailwinds at work, the net effect of which is hard to gauge. There are two main challenges:
The first is the sheer size of the U.S. Treasury market, a total of $5.8 trillion outstanding, with $4 trillion of that in maturities of longer than one year. It would take a huge effort to influence the level of long-term yields. To be sure, the Fed has a near-limitless ability to print money and expand its balance sheet by purchasing large amounts of Treasuries, but such an undertaking has never been tried before, so its effectiveness is unknown. Despite the Fed's deep pockets, it is a very expensive proposition with an uncertain tipping point (that is, the amount of purchases required in order to make a measurable difference on the level of yields).
The second potential complication for the Fed has to do with China and the global economic downturn. The recession is likely to lead to a slower pace of that country's accumulation of foreign reserves and, as a result, to a plausible inability of the biggest foreign holder of Treasuries (currently more than $700 billion) to keep up with the spike in new supply. This would leave the Fed with a bigger gap to fill in its own program of buying government bonds.
However, one moderate counterweight that could help the Fed's efforts would be that in the midst of a deepening recession, corporate bond issuance has dried up (except for a few notable exceptions like Cisco's $4 billion bond sale this week). By some projections, the net issuance of new corporate bonds will be close to zero or even slightly negative this year. If we assume that investors have a need to purchase a certain combined amount of corporate and government debt in any given period, the dramatic pullback in the issuance of corporate bonds may lead to a pickup in the demand for Treasuries.
In any event, there is no dispute that the amount by which the Fed's balance sheet has already expanded, and is projected to expand even more, is simply mind-boggling. As a result, questions have been raised as to whether that trend will come back to haunt the economy in the form of higher inflation.
Such concerns are largely off-the-mark and based, at least in good measure, on a misconception as to the role of newly printed money in creating inflation. Consider the following example:
The Fed prints, say, $7 trillion worth of $100 dollar bills (representing roughly 50% of the size of the economy's current GDP) and all of those bills are neatly stacked up in a large room, the windows and doors of which are all locked -- no bills are taken out of the room. As a result, all of that enormous amount of newly printed money stays inactive, not generating any additional economic activity (although that would have presumably been the Fed's original intent for doing so). No increase in spending and demand for goods and services are generated, hence no inflation.
This is very close to the reality confronting the Fed today. Despite its relentless efforts to provide massive amounts of liquidity in the last six months or so, banks are not lending given their own serious predicament, and that liquidity is having no impact on either economic activity or inflation. It is not how much money the Fed prints but how much of that money is actually circulating in the economy (or is leaving that room where it is locked up in the above example).
The Fed is acutely aware of the need to start mopping up that excess liquidity, very quickly after the economy starts showing signs of making a gradual comeback. Leaving short-term rates at zero, or purchasing large amounts of Treasury securities, are not policies meant to last forever. The Fed is in a crisis mode now and has the burden of preventing the financial system from disintegrating until a more comprehensive rescue plan for the banking system is well in place and shows some early results.
Differently put, everything is a matter of timing for the Fed. Dealing with a crisis of epic proportions comes first and worrying about the excess liquidity that was created in that process comes later.
First things first. This is not remotely close to the time where we should worry about the inflationary implications of the Fed's actions.
Anthony Karydakis is a former chief U.S. economist for JP Morgan Asset Management and currently an adjunct professor at New York University's Stern School of Business
