The Federal Open Market Committee, that group whose interest rate decisions we used to care about back before the Federal funds rate settled down around 0.15%, moved markets this afternoon with its announcement that it was going to buy lots more mortgage securities (up to $750 billion more) and start buying long-term Treasuries (up to $300 billion worth) for the first time in a very long time.
It was a somewhat surprising announcement, given that the Fed has so far purchased only $69 billion of the $500 billion in Fannie Mae, Freddie Mac and Ginnie Mae mortgage securities it had already committed to buying, and Fed chairman Ben Bernanke had been giving hints that he wasn’t quite ready to start buying Treasuries yet. Stock and bond markets initially took it as good news—a sign that the Fed still can do a lot to keep lending going to ease the recession.
But the stock market rally didn’t last long, and it probably shouldn’t have, because the Fed’s move into the long-term Treasury market is a momentous and somewhat unsettling one. As the federal government issues trillions in new debt to finance stimulus spending and the daily operations of government, the quasi-governmental Fed will now be buying hundreds of billions of it, in the process creating new money out of thin air (the Fed doesn’t actually have money set aside to buy stuff; when it buys something, the money suddenly, magically exists).
It’s a very weird, somewhat circular transaction, and it was last done in a big way during World War II. At the time the Fed wasn’t so much making monetary policy as doing its patriotic bit to finance the war (it was a de facto division of the Treasury Department at the time), but it worked on both counts: The deflationary tendencies of the 1930s were finally fully expunged from the economy, and we beat the bad guys. Later on, Milton Friedman described this kind of transaction as the functional equivalent of a “helicopter drop” of money, and after Ben Bernanke mentioned this in a speech in 2002 he became known as Helicopter Ben. Now he’s finally living up to the name.*
Will it work? In the sense of fending off deflation, yeah, this should have an impact. But the financial world and America’s position in it are more complicated than in the 1940s. We now owe lots of money to creditors outside the U.S., and when they see the Fed buying long-dated Treasuries they’re bound to start worrying about what that means for the dollar. If they get too worried, they could drive up interest rates here and counter the impact of the Fed’s purchases. So there are limits to the Fed’s magical powers, and they already began showing up in currency markets this afternoon, with the dollar falling sharply against the euro and other foreign currencies. The adventure continues.
* Both Friedman and Bernanke were talking about a tax cut financed by Fed purchases of long-term Treasuries, but it seems to me that the current mix of stimulus, tax cuts, entitlement spending and falling tax receipts due to lower incomes is more or less equivalent.