CHARLESTON, W.Va. -- In pursuit of their ultra-low interest rate policy to support economic recovery from the Great Recession of 2008-09, the U.S. Federal Reserve, has purchased more than $3 trillion of Treasury debt and mortgage bonds from banks and security dealers in three separate operations known as Quantitative Easing (QE).
These Fed purchases since November 2008 put enormous amounts of money into the hands of banks and succeeded in forcing the short-term interest rate to near zero percent and long-term rates to record low levels. As of now, the Fed continues to buy $85 billion of bonds a month and intends to hold down interest rates until mid-2015. The purpose is to encourage borrowing, spending and investing until unemployment drops to at least 6.5 percent, with inflation remaining under 2.5 percent.
Compared to the history of recoveries from the last 10 economic recessions, the current recovery has been slow, averaging about 2 percent a year. The national unemployment rate has very sluggishly dropped from 10 percent in 2009 to 7.7 percent in early 2013. The stock market has recovered very well, but the national debt and the budget deficit, at $16 trillion and $1 trillion respectively, raise the red flag to many.
Supporters of the easy money policy would argue that the economy would have done far worse in the absence of Fed intervention. Since the end of the $814 billion fiscal (tax and spending) stimulus program, the QE policy of low interest rates has been the "only game in town" propping up economic recovery. However, there is agreement among economists as well as politicians and government officials regarding the risks of continuing with the QE policy, uncontrollable inflation being the major one. Critics of cheap money policy point out that the ultra-low interest rate on U.S. Treasury bonds and bills engineered by the Fed is also encouraging politicians to kick the debt-and-deficit can down the road.
The fear of inflation has its roots in the enormous amount of money that banks have accumulated as a result of the three QE operations, a lot of which still resides in their reserve accounts with the Fed. Any excess of this money beyond what the banks are legally required to hold, currently $1.7 trillion, may be loaned out or invested by the banks as the economy continues to recover. The danger is this flow of cheap loans may fuel the economy's demand for goods and services at a rate that businesses may not be able to keep up with. Left uncontrolled, this demand pressure could trigger a serious bout of inflation, consequently higher interest rates. The other danger is the situation spinning out of Fed's control.
To avoid this risk, the Fed would want to roll back its cheap money policy when they are convinced that the economic recovery has taken hold -- allowing interest rates to rise back some to preempt wild inflation. To do so, the Fed would perhaps first taper off buying bonds and, later, might want to start selling back bonds that they had bought. At that point, the game gets tricky.
The bond market would expect prices to fall resulting in a bond-selling spree possibly triggering a precipitous free fall in bond values and steep increase in interest rates on the flip side. If the worst-case scenario plays out, we could see a return of the financial crisis if the bond market is destabilized enough and the flow of short-term loans slows to a trickle like they did during the financial crisis of 2008.
Stocks could deflate rapidly along with other risky assets which investors had bought to avoid low yields on government bonds. Supply of margin loans to buy stocks could dry up.
With declining bond values, a result of rabid bond sales, we run into another awkward situation -- the Fed would need to shed tons of bonds to trim bank reserves by any given amount. What if they get sold out too soon?
One way for the Fed to avoid all these risks would be to not bother to sell back bonds, instead just let them reach maturity over the next few years. This policy may work if the economy continues to grow slowly so banks continue to burn their excess reserves slowly due to low demand for loans. But what if economic recovery gains momentum so loan activity shifts into high gear?
Fed Chairman Ben Bernanke has recently asserted that none of these needs to happen -- the "fear factor" is overblown. He asserts and assures that the Fed has put in place tools that can handle any upsurge in demand for loans by consumers and businesses.