What’s the Fed Doing?

BernankeYou may or may not have heard that the Fed is doing something it hasn’t done in about 40 years or so. They are going to buy long term Treasury bonds straight from the Treasury. This sounds crazy: why is the government buying something from itself, what is that going to accomplish?

I would be disingenuous to suggest I fully understand. But here is what I do know. The Fed is scared of deflation, probably because Ben Bernanke (the fed chief, see picture) is a student of the Great Depression. One of the many mistakes that made the Great Depression so “great” was that the fed was too “tight” with the money supply. This means that they did not print enough money to satisfy the number of goods and services in the economy. This creates deflation (drop in prices). At first glance, deflation may sound like a good thing since everything becomes cheaper. The problem is, when people expect prices to be less in the future they stop spending money while waiting for prices to drop further. This crushes the economy, and eventually we would have to settle for smaller paychecks. People generally don’t care for shrinking pay, therefore, the Fed tries to keep inflation small and positive to give them enough buffer against deflation.

In the current crisis, people stopped spending money out of fear and the lack of available credit. This drop in “velocity” also can cause deflation since retailers will be forced to drop prices to keep selling their wares. The only way for the Fed to counteract this is to print more money. Usually, they do this by dropping their target Fed funds rate and then buy and sell treasuries (US bonds) on the open market to keep the rate at that level. The lower the rate, the more new money gets into the economy. The rate in currently near zero, so the Fed is pumping money as fast as it can using the market. Since it would like to put more money in it’s only avenue is to “monetize” the debt. This is where it gets fuzzy for me.

Monetizing the debt means it buys treasuries straight from the Treasury (follow?). Then the Treasury uses the money like it would any other money it raised from selling bonds, to finance the government. Instead of taking money out of the economy by selling bonds to people, the bonds are bought with newly printed money from the Fed. Thus, the newly issued debt is turned into new money and the new money is put into the economy. This, I believe, is where the term monetizing the debt comes from – turning debt into money.

Now, this opens a whole can of worms I can’t get into in this post as to whether this is a good or bad idea and what the consequences are. I wrote this, first, to see if I understood it, and second, to try to relay the information to those even more layman than me. Here is how I see it as of now. There are many people who are not worried about deflation as much as the Fed, and some who are much more worried about inflation (which happens when the Fed prints too much money). The Fed is definitely printing a TON of money. The likely outcome is we will avert deflation easily and economic growth will resume in the about another three months. The Fed will not be able to soak up all the extra money as well as it needs to (something it promises to do) and inflation will be high over the next couple of years. This is a hit we will just have to deal with because a little too much inflation is a much better outcome then even a little deflation.

I hope this is fairly clear to most, but if there are any questions please leave a comment. I’d be happy to update it.

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2 Responses to “What’s the Fed Doing?”

  1. Clay Says:

    I actually found this semi-interesting. Trust me, that’s saying a lot being as I’m usually far too content to wallow in my own financial ignorance. Usually I just glaze over when such topics come about.

    It does somewhat make sense to turn bonds into cash. What good is a bond if no one has actual money to buy them? I really have no idea what I’m talking about, but you did make me stop and think about it for a second so I suppose that’s worth something!

    • mikehinton Says:

      Thanks a lot, I take that as a huge compliment. The ability to inform someone that otherwise wouldn’t be interested is one of my highest goals with this blog.

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