Is the Fed creating trillions of dollars out of thin air?
"The Fed finds innovative ways to pump hundreds of billions of additional dollars into the economy
A few days ago Ben Bernanke, chairman of the Federal Reserve, was asked to identify the biggest obstacle to economic recovery. That 'we don’t have the political will,' he replied.
Mr Bernanke showed his own will on Wednesday March 18th, when the Fed’s policy panel said it would purchase $300 billion in Treasury debt, mostly maturing in two to ten years, starting next week. It will also boost its purchases of mortgage-backed securities to a total of $1.25 trillion from a previously announced $500 billion, and its purchases of debt issued by Fannie Mae and Freddie Mac, the mortgage agencies, to a total of $200 billion from $100 billion.
The Fed had already said it was considering Treasury purchases, but expectations had waned in recent weeks. The announcement electrified investors, sending the Dow Jones Industrial Average up by 91 points, or 1.2%, and the ten-year Treasury bond yield down a stunning 50 basis points to 2.51%.
The plans are awe inspiring in their scale, but they are different only in degree rather than kind from the steps the Fed has already taken. In December, it exhausted its supply of conventional monetary ammunition when it lowered its short term-interest rate to between zero and 0.25%. At that time it had already started unconventional operations: expanding loans to banks and other financial institutions; buying private commercial paper; making enormous and controversial loans and loan guarantees to AIG, Bear Stearns, Citigroup and Bank of America; and setting up a facility, capitalised by the Treasury, to buy securities backed by car, student and small-business loans, and mortgages. By the time its new steps are done, the Fed’s balance sheet will reach $4.5 trillion, or about a third of GDP, up from less than $1 trillion a year ago, Capital Economics estimates.
All these steps were aimed at reducing credit spreads on private loans and increasing the supply of private credit, currently constrained by fear of counterparty default, illiquidity and banks’ depleted capital. They have worked to some extent, as spreads on private debt have come down, though they remain well above pre-crisis levels.
Taking the added step of buying Treasuries made some inside the Fed uncomfortable. It amounts to monetising government debt—in essence, allowing the government to finance its spending with newly printed money rather than higher taxes. That raises two fears: that it would eventually lead to inflation, or even hyperinflation, and that it would compromise the Fed’s independence."