Between rock and a hard economy

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illustration – Jörn Kaspuhl

With an announcement by the Federal Open Market Committee (FOMC) expected next week, the question that needs to be answered is whether the Fed should step in to rectify the situation and how much will be enough to address the problem. The two folds of the question are important and both have to be negated in a manner that balances the good with the bad.

The first part of the question is whether there is a need for a stimulus or signal from the Fed. Let’s look at the facts first. The US economy is tanking. Pressures from abroad have had a dragging down effect on the US economy and the cause has not been helped by the economic data that has been released in the last few weeks. Announcement after announcement has shown that the recovery that was being seen has faded away. Other countries have tried to rectify the situation by changing their internal policies. Monetary tools have been used to give a short term relief in China, South Korea, Japan and the eurozone.

Added to this is the fact that as time passes, the option of another quantitative easing seems to be becoming more of a need of the hour. As interest rates are already at a record low of 0-0.25%, the only other option is to inject some liquidity into the system through a bond repurchase. So to answer the first part of the question, there is a need for some sort of action by the Fed. This has also been reinforced in statements by the Fed Chairman who has hinted towards an asset purchase come 1st August. Ben Bernanke has asked the Congress to do more in order to provide support to the fledgling economy and the IMF chief has also joined into calls to do something as soon as possible.

All these arguments show that action is required so now the new issue is how big of an action is required? The key question is what action will the Fed take which is substantial enough to stimulate the economy while trying to control inflation and not to suffocate the private sector in the process. If excessive buying of treasuries is carried out, it will leave less for the private sector to acquire the share left for them and taking over their portion of the market. Due to this, mortgage-backed securities and other new tools are being looked which are more readily available in comparison. Last week’s testimony by Bernanke was used to shed light on the options being considered to reverse the economic slowdown and buying mortgage bonds and using new tools to reach old goals was outlined as part of the solutions being analysed. Till now $2.3 trillion in bonds have been purchased and other solutions are being considered as this solution has exhausted its utility and timeframe.

The first challenge that will be faced will be to try to maintain stability in the Treasury market which will get disrupted with any asset purchase while still not doing enough to stimulate the economy. The Fed has the mandate of carrying out both these functions so the best solution would be to purchase assets in a new market. FOMC has already prolonged Operation Twist which was formulated to decrease borrowing cost by extending maturities of assets on the balance sheet. This will already cut down the costs of borrowing for the Fed. Now this advantage has to be used to reap benefits for the economy as well. The effects can already be seen in the yield where they have fallen to all time low in recent weeks and declining mortgage rates for consumers. The solutions available on the table for the Fed include mortgage bonds, agency mortgage back securities (MBS) and other MBSs which can be used for this purpose.

It is obvious that a new solution is required as any further use of Treasuries would tilt the market in the Fed’s direction with them owning a huge chunk of the available securities. It will also nullify any growth that the private sector would be able to achieve and would have the negative desired impact. In this environment, other options seem more attractive and viable. However, the same reasons of liquidity and market functionality should also be kept in mind with regard to other markets as well. The Fed can also overwhelm these thin, liquidated markets as well and disrupt the function of these mechanisms. A deep look is required into all the solutions available at its disposal and the most efficient path should be chosen. The margin of error is getting tighter day by day and 1st August cannot get here sooner for the capital and commodity markets.

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