The Fed surprised markets by announcing another massive expansion of its balance sheet in process known as quantitative easing (QE), which is frequently referred to as 'printing money.' In addition to prior asset-purchase programs, the Fed announced plans to buy an additional $750 bio of GSE mortgage-backed assets, between $100-200 bio in other government agency back debt, and $300 bio in US Treasuries, for a total of up to $1.25 trillion. Certainly the amounts are staggering and indeed the moves will result in a significant expansion of the money supply.
Why did the Fed do this now and what are the aims of the plan? Many market analysts, myself included, expected the Fed to wait for the implementation of the TALF (Term Asset-backed securities Lending Facility), which is designed to restore consumer lending (e.g. car loans and credit cards), before deciding whether to embark on QE. So the timing of the Fed move was initially interpreted as a sign that the economy is much worse off than thought; as conspiracy theorists would say: 'The Fed knows something we don't.' More likely, the Fed decided that delay posed a greater risk and that bold action now may forestall even worse deterioration in the economy. In tandem with Treasury efforts to stabilize the banking sector, the Fed is aiming to drive down consumer lending interest rates, having exhausted traditional interest rate cuts.
Buying US Treasuries sends Treasury prices higher/yields lower, dropping the interest rate used to set all manner of consumer and business lending, from mortgages and credit cards, to working capital loans. The expectation is that lower lending rates will support consumer spending, particularly when it comes to mortgage refinancing. The move is intended to help stabilize the housing sector by allowing troubled homeowners to refinance at more affordable rates, breaking the cycle of defaults and foreclosures, leading to lower home prices, which lead to more defaults and foreclosures. More solvent homeowners may also take advantage of lower rates to refinance, generating monthly savings that may translate into higher personal spending. In short, the hope is that lower borrowing costs will generate higher consumption.
The reality is a tad more complicated. Just because banks and financial firms may be more willing to lend and borrowing costs may fall does not mean that consumer borrowing demand will materialize. Many homeowners are underwater or otherwise unable to refinance, and many households are still retrenching from prior excessive debt levels. But the Fed/Treasury efforts are addressing the only two elements of the credit equation which they can directly influence: the cost and availability of credit. The demand side of the equation will depend on how consumers respond, which remains uncertain. In short, the Fed's QE amounts to a massive effort at providing an environment supportive of future consumption, which provides more than a glimmer of hope of arresting the current downturn.
The effects on the USD have been decidedly negative, at least in the short run. As I'll suggest shortly, though, QE need not be a death knell for the greenback. The USD was sold on the proposition that a massive increase in the money supply lessens the value of every dollar out there. That supply-demand logic works in the case of hard commodities, but does not look as solid in currencies, which are relative-value instruments. When you sell USD, you're buying some other currency, and at the moment alternatives to the USD are not especially appealing. Also, part of the extreme USD decline stems from the 'surprise' element of the announcement. While the Fed had telegraphed it may undertake Treasury buying after its December meeting, the timing still caught many off-guard, as I suggested above. In cases of surprise information flows hitting the market, excessive reactions are the norm. Once cooler heads prevail and the information is better digested, the initial reaction is frequently reversed. However, the risk in the current situation is that many institutional investors were caught flat-footed and are still overly long USD, potentially leading to a more drawn out USD selling phase.
Why did the Fed do this now and what are the aims of the plan? Many market analysts, myself included, expected the Fed to wait for the implementation of the TALF (Term Asset-backed securities Lending Facility), which is designed to restore consumer lending (e.g. car loans and credit cards), before deciding whether to embark on QE. So the timing of the Fed move was initially interpreted as a sign that the economy is much worse off than thought; as conspiracy theorists would say: 'The Fed knows something we don't.' More likely, the Fed decided that delay posed a greater risk and that bold action now may forestall even worse deterioration in the economy. In tandem with Treasury efforts to stabilize the banking sector, the Fed is aiming to drive down consumer lending interest rates, having exhausted traditional interest rate cuts.
Buying US Treasuries sends Treasury prices higher/yields lower, dropping the interest rate used to set all manner of consumer and business lending, from mortgages and credit cards, to working capital loans. The expectation is that lower lending rates will support consumer spending, particularly when it comes to mortgage refinancing. The move is intended to help stabilize the housing sector by allowing troubled homeowners to refinance at more affordable rates, breaking the cycle of defaults and foreclosures, leading to lower home prices, which lead to more defaults and foreclosures. More solvent homeowners may also take advantage of lower rates to refinance, generating monthly savings that may translate into higher personal spending. In short, the hope is that lower borrowing costs will generate higher consumption.
The reality is a tad more complicated. Just because banks and financial firms may be more willing to lend and borrowing costs may fall does not mean that consumer borrowing demand will materialize. Many homeowners are underwater or otherwise unable to refinance, and many households are still retrenching from prior excessive debt levels. But the Fed/Treasury efforts are addressing the only two elements of the credit equation which they can directly influence: the cost and availability of credit. The demand side of the equation will depend on how consumers respond, which remains uncertain. In short, the Fed's QE amounts to a massive effort at providing an environment supportive of future consumption, which provides more than a glimmer of hope of arresting the current downturn.
The effects on the USD have been decidedly negative, at least in the short run. As I'll suggest shortly, though, QE need not be a death knell for the greenback. The USD was sold on the proposition that a massive increase in the money supply lessens the value of every dollar out there. That supply-demand logic works in the case of hard commodities, but does not look as solid in currencies, which are relative-value instruments. When you sell USD, you're buying some other currency, and at the moment alternatives to the USD are not especially appealing. Also, part of the extreme USD decline stems from the 'surprise' element of the announcement. While the Fed had telegraphed it may undertake Treasury buying after its December meeting, the timing still caught many off-guard, as I suggested above. In cases of surprise information flows hitting the market, excessive reactions are the norm. Once cooler heads prevail and the information is better digested, the initial reaction is frequently reversed. However, the risk in the current situation is that many institutional investors were caught flat-footed and are still overly long USD, potentially leading to a more drawn out USD selling phase.
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