The Federal Reserve Board’s Federal Open Market Committee continues to convey the sentiment that the economy is still fragile and the future remains uncertain. A clear message on September 21 was that the Fed would step in if necessary to support the recovery and assure that inflation returns to a level that is in accordance with the Fed’s mandate. Ideally, the Fed would like inflation to be between 1.5 and 2 percent; currently it is at 1.1 percent.
One tactic that the Fed has at its disposition is to enter into another round of quantitative easing, cleverly called “Q.E. 2.0” on the street. The Fed would likely buy longer-dated treasuries because individual and corporate borrowing rates are based on long-term yields. The idea would be that the Fed would buy treasuries from the market as other assets on its balance sheet begin to naturally roll off, as well as buy additional treasuries to expand the total of the balance sheet, which, by the way, has tripled since the start of the financial crisis. The effect that the Fed anticipates is that the additional liquidity pumped into the economy would ignite growth while getting inflation at a preferred level. As the Fed purchases treasuries, prices will rally with increased demand and drive down yields. Reduced yields would encourage banks to lend money in order to earn a higher return than what they would earn in treasuries, and would encourage companies to find alternative uses for their cash.
Treasury yields are the benchmark for other asset classes. This implies that prices of other asset classes will also rally, leading to opportunities for companies to sell out of their investments at a profit and use the cash for growth-inducing activities such as hiring new employees, purchasing new machinery, or strategically acquiring other companies – all events that would help spur the economy. However, there is no assurance that the economy will react as the Fed anticipates. Unfortunately, economics is not a precise science and exogenous factors might interfere, or counteract the Fed’s actions. Some potential repercussions include increased devaluation of the dollar, revisit of inflationary fears, and all-time highs in the price of gold.
In the short run, especially through November until the Fed decides whether to implement Q.E. 2.0, the market will anticipate some kind of quantitative easing and in the meantime treasuries will rally and other related securities will follow suit. In the long run, if the Fed does decide to move forward with the purchase of treasuries in November, there is no guarantee Q.E. 2.0 will ward off deflation or bring inflation to a comfortable level. Until companies feel that the consumer is back and their profits are sustainable, it is hard to imagine that they will start to hire employees on a greater basis. Lower interest rates will heighten the chances that U.S. financial institutions will look to take on more risk lending to private borrowers and business. Lower rates would also help encourage the private sector to invest in itself and spur growth. However, there is no sure outcome, and so it is most probable that the Fed will err on the side of re-igniting the economy and deal with the consequences later. The Fed has battled high inflation in the past and is willing to do it again to stimulate the sluggish economy.
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