Posted on Thursday, November 4, 2010
WASHINGTON — In its latest move to help the economy, the Federal Reserve is about to restart its monetary printing press — or rather, the electronic equivalent.
The Fed announced Wednesday that it intended to buy $600 billion in Treasury securities through June. It also signaled that it could make more purchases after that if unemployment remained too high and inflation too low.
The Fed is prohibited from directly lending to the Treasury Department, which issues government debt. So the Fed buys government securities on the open market from “primary dealers,” a network of 18 institutions, including Goldman Sachs and Morgan Stanley, that constantly trade in such securities, both for their own accounts and on behalf of clients, including other financial institutions around the world.
While monetary policy is set at the Fed’s headquarters here, it is carried out in Lower Manhattan, at the Federal Reserve Bank of New York, which buys and sells Treasury securities and other assets on the Fed’s behalf.
An adage among economists is that “the Fed creates reserves and banks create money.”
In typical recessions, the Fed pumps money into the economy by buying assets like government bonds and creating an equivalent amount in liabilities — reserve deposits that commercial banks keep at the Fed. Those deposits, currently over $1 trillion, along with currency in circulation, now $961.4 billion, make up the monetary base — in essence, the raw material from which money is created and made available to consumers and businesses.
If banks were to quickly start using the reserves to make loans, the supply of money, currently $8.7 trillion by one estimate, could grow rapidly and lead to inflation even as the amount of reserves remained constant. The supply of money includes not just currency, but also things like bank deposits, savings accounts and money market funds.
For now, that seems highly unlikely. Banks say there is not much demand for loans, though some business owners say credit is too difficult to obtain.
Because current conditions are so dire, the Fed is now not only expanding liquidity but also focusing its purchases on Treasury securities — from bills maturing in 18 months to bonds maturing in 30 years — that have an average maturity of five to six years. Those purchases should drive up the prices of these securities (because there will be more demand) and consequently push down medium and longer term rates (because bond yields move inversely with prices).
The Fed bought $1.7 trillion in assets from December 2008 to March 2010. As of last week, the Fed held $834 billion of Treasury securities and nearly $1.1 trillion in mortgage-backed securities on its balance sheet.
But the volume of mortgage-backed securities on the Fed’s balance sheet is gradually shrinking as mortgage loans are paid off early (usually because they are refinanced) or reach maturity.
To prevent such shrinking, which would have the undesired effect of contracting the Fed’s balance sheet, the Fed announced in August that it would reinvest the proceeds from the mortgage-related holdings in Treasury securities — about $35 billion a month. The Fed said Wednesday that it would continue those reinvestments through at least June.
Economic theory holds that unemployment is currently so high, and inflation so low, that the Fed should lower short-term interest rates. But those rates have been near zero since December 2008.
By some estimates, the Fed would have to buy as much as $5 trillion in Treasury securities to simulate the effects of lowering short-term rates as much as they should be lowered. But an amount that large is seen as unrealistic; it would sharply devalue the dollar and could unmoor inflation expectations and cause long-term rates to rise — the opposite of what the Fed wants. Fed officials believe the $600 billion action announced Wednesday will be similar to lowering the benchmark Federal funds rate by 0.75 percentage points.
The Fed can buy only so much debt. Among other constraints, it does not control how much debt the Treasury issues, and there are only so many securities available in the open markets. In addition, the Fed has not allowed itself to own more than 35 percent of the outstanding amount of any particular security.
On Wednesday, the New York Fed said that it was “temporarily relaxing” the 35 percent limit to give itself flexibility but said it would exceed the threshold “only in modest increments.” By SEWELL CHAN