The Fed Acts

Look for Bernanke to be burned in effigy at the next meeting of the Republican Party leadership. In defiance of the brazen attempt to interfere with Fed independence by that leadership – if that word is appropriate – the Fed announced today that it was going to engage in yet another new trick in order to support the economy. Citing continued, and possibly worsening, economic weakness the Fed unveiled a new trick.

It is a variant on the “twist” strategy last deployed in the 1960’s. In this latest version the Fed will sell off about $400 billion in short term treasury bonds, and buy an equivalent amount of longer term bonds. The idea being that this will influence the slope of the yield curve – the difference between short term and long term interest rates. A large shift into longer term, and thus more risky, assets should drive those rates down. By adding its own demand to the normal market demand for longer term securities the Fed will have the effect of driving down their interest rates. Conversely it will, of course, have the opposite effect at the short term end of the maturity spectrum. The net result will be to reduce the risk premium on longer term assets and thus makes investment more attractive. The desired outcome of the entire effort being to encourage business and household investment by reducing the cost of borrowing in the range of maturities normally associated with private sector activity in the real economy.

Will it work?

Well the 1960’s attempt at a similar thing is widely regarded as a flop. But circumstances were different back then. Now we are in a liquidity trap; businesses are awash with cash; and households are still digging out of debt. This is not an auspicious combination. So the context for the Fed’s initiative is not good. Still, we should give them marks for effort. Which is more than we can say for the folks over in Congress. There, it seems, all the effort is being applied to doing nothing.

As an addition, and just to rile the Republicans even more, the Fed also said it was going to reinvest more of its maturing cash flows in mortgage backed securities rather than in regular Treasury bonds. This is aimed to help provide more help to the real estate market, via an inflow of liquidity. Again, it might have little effect. But at least Bernanke is trying.

One last thing: the usual suspects on the Fed Board opposed the initiatives. Those people – Plosser, from Philadelphia; Fisher, from Dallas; and Kocherlakota, from Minneapolis, all objected to any kind of stimulative effort. According to these three the economy is in ruddy health, needs no help, and thus any stimulus will ignite horrible hyperinflation. They have all been wrong consistently since the crisis erupted, so it is re-assuring to see them maintain that consistency. It means we assuredly need to do something. Probably a lot more drastic than what was announced today.

But we are forced to accept what little help we can.