Will The Fed Step In?

The Federal Open Market Committee of The Fed will meet later today.

The question is what, if anything, does The Fed have up it’s sleeve for balancing the economy. That is, after all, it’s whole purpose in life.

Federal Reserve Bank: Governance Board

I’m gonna go out on a limb here and predict what The Fed will do…

Will The Fed step in? Ans: “yes”.

The Fed will announce another round of quantitative easing. It will be called “QE3”. It will probably be in the range of $1 trillion to $1.5 trillion. That is a lot!

Wall Street will be ecstatic. Stocks will soar.

————————————————————————————————–

NOTE-8/9/2011, 6/59PM PDT:

After The Fed met today they released this statement:
FOMC Statement 8/9/2011

I was wrong. There was no QE3 announcement!

They admitted the economy is not doing as well as they thought and “now expects a somewhat slower pace of recovery over coming quarters than it did at the time of the previous meeting”.  They will target Fed lending rates at “exceptionally low levels” from 0-1/4% through mid-2013. Duh! Tell us something we don’t know. 😉

They concluded, though, saying they “discussed the range of policy tools available to promote a stronger economic recovery” and “will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate”.

Prepare yourself… QE3 is on the way.

————————————————————————————————–

How Do I Know?

I don’t. Mine is a semi-educated guess from a non-economist based on the function and purpose of The Fed and an evaluation of the remaining tools The Fed has left in its arsenal.

Allow me to explain…

A Little Traveling Music, Please!

The Fed was created back in 1913 to deal with just the kind of situation we face this very day, 8/9/2011!

Before 1913 we experienced huge crashes in the financial sector where money dried up like Death Valley in summer. They occurred with disturbing regularity. They were called “panics“. The panic of 1907, for example, resulted when the New York Stock Exchange lost 50% of its value. The Fed was created to prevent that from happening again.

The situation today isn’t as bad as 1907, but the stock market has lost about 18% of its value this summer. It certainly rates attention from The Fed.

Ben Bernanke is its current chairman so when you hear that name bandied about in the news you know they are talking about The Fed.

The Fed’s primary responsibility is to stabilize the monetary system and maintain “liquidity” in banks to keep us out of Death Valley so we can still afford to chase Valley Girls.

What is Liquidity?

Liquidity is the speed with which an asset can be converted into cash. When you need money and all you have is a warehouse full of product you can’t sell because of low demand then you don’t have liquidity.

Cash itself, of course, is the most liquid asset of all. That is where The Fed comes in.

How Does The Fed Manage The National Economy?

The Fed manages the country’s banking financial cash reserves. It controls the money supply. It loans money to the major banks as they need it to keep the economy flowing smoothly.

The Fed tweaks the national economy in these ways:

  1. Changing interest rates charged to the major banks
  2. Buying and Selling of Treasury Securities
  3. Quantitative Easing

The Fed usually regulates inflation and contraction through the interest rates it charges banks to borrow from the central reserves. It buys and sells treasury securities to maintain the “Full Faith and Credit” of the United States.

1-Changing Interest Rates

If The Fed raises interest rates then it causes interest rates for regular folks like us to go higher. Home and auto loans cost more. It also costs businesses more to borrow money to expand and create jobs. Us regular folks often refinance our home loans after The Fed lowers its interest rates and the cost of money goes down.

High interest rates are not our current problem. In fact, we are near historic lows.

The Great Recession of 2008, to say the least, contracted the economy. To combat that The Fed lowered interest rates to zero.

Ironically, the mathematical models The Fed depends on for decision making actually said The Fed should be paying the banks to take their money… up to 5%!!

Fed interest rates can’t get lower than they are right now.

There is nothing more The Fed can do with interest rates to help the economy.

2-Buying and Selling of Treasury Securities

All these treasury securities we’ve been hearing talked about so much in the news lately are bought and sold through The Fed.

Typically a government entity – federal, state and/or local – issues bond sales approved by The Fed to finance infrastructure projects and stuff like that. The price agencies agree to pay back for the securities includes interest. Investors buy those securities because they are a safe way to make a profit.

Selling treasury securities for one reason or another is the source for all public debt. China is our biggest creditor because it owns more treasury securities than anyone outside the government and The Fed.

One result of the Great Recession of 2008 is that The Fed bought up all the toxic loans backed by the then quasi-government mortgage giants Fannie Mae and Freddie Mac.

9/8/2008, a date that will live in economic infamy, the federal government assumed ownership of Fannie and Freddie and The Fed bought their debt obligations. The Fed took on their losses by becoming responsible for paying them off.

In banker terms that means The Fed seriously increased its “exposure”, the amount it can lose in an investment because that investment is unprotected.

Some estimate that might cost The Fed upwards of $700 billion.

Fannie and Freddie were government’s very, very naughty step-children when left alone to their own devices. They caused the Great Recession!

As a result, The Fed has used up it’s 2nd means of managing the economy.

That leaves only one more…

3-Quantitative Easing

The way quantitative easing works is that The Fed purchases financial assets from banks and private sector businesses with “new” electronically created money. That makes it available as “excess reserves” to be spent.

It is also called expansionary monetary policy because, basically, it upgrades the value of country’s economy at the snap of someone’s fingers. Nothing to it.

To you and me it means just printing money out of thin air.

It is an unconventional monetary policy (Duh!) used by a central bank, like The Fed, to stimulate a national economy when conventional monetary policy has failed.

Guess what? Conventional monetary policy has failed!

The Fed only has quantitative easing left as a way to stimulate the economy.

Unfortunately, The Fed has already applied quantitative easing twice since 2008 because of the Great Recession and, so far, it hasn’t worked. Those two previous tries are called QE1 and QE2.

QE2 ended at the end of June.

Conclusions

Given what we know, The Fed has only has one course of action left to it to help the economy – quantitative easing.

The economy desperately needs something to happen. We are in trouble.

Given that QE2 just ended a little over a month ago we are open again to another round of quantitative easing – QE3.

That is likely what The Fed will announce today.

And given that the last two rounds were ineffective a larger QE3 is called for. QE2 was $600 billion.

Is it a good idea? Will it work?

Those are questions that remain to be answered.

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About azleader

Learning to see life more clearly... one image at a time!

Posted on Aug 9, 2011, in Debt, Economy, Federal Reserve, Federal Reserve Bank, FOMC, Politics, The Fed. Bookmark the permalink. 2 Comments.

  1. Okay. Let this armature arm chair economist give it a whirl. Historically, when governments create money out of thin air, inflation ensues maybe even hyperinflation. that hasn’t happened here with QE1 and QE2. Banks are flush with money, corporate profits are up and, the stock markets have boomed; but, the money isn’t circulating through Main Street. Banks, we are told are sitting on close to $2 trillion in excess reserves. Corporations, we are told, are sitting on over $1 trillion in cash. Now, world markets get nervous over the economic outlook for Europe and the Us and investor start selling of and run to the US bonds as a save haven. But investors can’t be happy with the miserable interest that the bonds are paying because the inflation we do have is wiping out any earnings.

    Something, my friend, has got to give!

  2. Excellent points!

    Perhaps the missing ingredient to kick start the economy is jobs.

    But jobs aren’t there because no one wants to invest even though the money is out there.

    Businesses aren’t investing because of the uncertainty in world markets and the possibility they will have to save their cash reserves to pay for increased U.S. taxes.

    The threat of higher taxes have been hanging over their heads since Obama became President.

    Its a catch-22 scenario.

    As a result, investors don’t know how to react. 😉

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