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The Fed’s bold move

March 19th, 2009 · 3 Comments

Some rays of hope, the plot thickens…

There isn’t anything else they can do. Monetary authorities have a reasonable grip on short-term interest rate, but for the economy as a whole, long-term interest rates matter more, as these drive the housing market and much of business investment.

So what to do if short-term rates are already almost zero? Indeed, try to get longer-term rates lower as well, by buying up longer-term securities, like government bonds. The prices of these vary inversely with the interest rates on them, so buying them in large quantities will rais their price and lower their rates at which they trade.

So far so good. Mortgage rates are falling, that’s good. However:

  • “They clearly bit the bullet,” said James Knightley, senior economist at ING Financial Markets in London. “There’s no guarantee that this will actually work. While they are expanding the money supply, it’s only going to generate economic activity if people actually borrow. You need the demand on the other side to actually get the credit growth.” [NYT]

This is a very acute observation. We have a couple of remarks:

  1. The dollar is also falling as a result of the Fed action, that’s good too, at least for the US. It’s another channel through which demand for US products and services will be boosted (albeit at the cost of the rest of the world). In two days, the dollar has fallen more than seven sents against the euro, that’s quite a reaction.
  2. Businesses and consumers are still very reluctant to borrow and spend, as the banks, they’re more focused to repair their balance sheets. This is another big risk for the economy, lowering interest rates, even the ones that matter the most, might not help a lot.
  3. To create demand for credit, goods, and services, the only party that can get spending going again is the Federal Government. Hence the stimulus package, which is not even big enough according to many economists.

There are some important risks in this these actions, like

  • Inflation
  • Unsustainable public deficits and debts

Inflation really isn’t something to worry about.

There are way too many idle resources in the economy right now to set of any inflationary pressures. In fact, some inflation would be good, as it helps restore battered balance sheets of banks, companies, and households, reducing the real value of their debt.

The real danger is actually the reverse, deflation leading to an increase in the real value of debt, setting off even more retrenchment in spending and borrowing, forcing more asset sales and lower asset prices and thereby slamming the economy into a deflationary vicious cycle.

Much of that excess liquidity now being injected into the system can also be taken away when the economy starts to grow again, when the slack in resource use is lessening and inflation would become a risk.

Unsustainable public deficits and debts?

A couple of things to keep in mind:

  • Doing nothing and not arresting the slide in the economy will also increase public deficits and debt levels, as tax incomes dwindle when incomes, profits and sales decline
  • By buying Government treasuries, the Fed not only takes some of the financing worries away (and increases the money supply in the process), it also lowers the rates the Government has to pay, reducing public finance cost.

All in all, we think that this bold move is excellent, we’re tentatively starting to see some flickering light at the end of the tunnel.

Tags: Public Policy

3 responses so far ↓

  • 1 Darcy Patten // Mar 19, 2009 at 9:09 pm

    What is the future of the US dollar though? They are out of control printing money.

    At some point down the road this is going to mean a dollar that is so devalued it will no longer be used as the world standard for currency.

    Perhaps, in the situation the US will become a massive export country like Japan. *shrugs*

  • 2 admin // Mar 19, 2009 at 9:12 pm

    They’re creating a lot of liquidity now, that the system needs it, but much of it can (and indeed should) be reigned in when more normal times return, so we’re not convinced about any long-term damage to the dollar.

    Europe might provide a lesson in what happens if you don’t take these measures on the scale the US is taking them, and we fear that the results will be worse (actually, they already are..)

  • 3 Darcy Patten // Mar 19, 2009 at 9:24 pm

    Well I look forward to those posts so you can educate me in those details.

    Indubitably you will start this suggestion 3 months or more before the feds finally read your blogs and then do something about it! 😉