Monday, December 29, 2008

Why is the Federal Reserve Buying US Treasury Bills?

The Federal Reserve are buying 30 year Treasury Bills in an attempt to increase the money supply and stimulate economic activity.

At the moment banks are reluctant to lend to the private sector. This is because the recession has made lending to private companies quite risky. Also, banks are reluctant to lend to each other because of the credit crunch. Banks are buying 30 year treasury bonds because they are seen as a safe investment. They may only yield 2%, but with interest rates at 0-0.25%, it does represent some profit for a bank; in addition it is seen as safe.

Because the Fed is worried about deflation and lack of credit, they are trying to get the banks to resume more normal lending practices (lending to each other and lending to private sector.

The Federal Reserve are buying treasury bonds because:
  • By buying bonds, the value increases and the interest rate on them declines. The Fed are trying to reduce interest rates on long term bonds to encourage banks to spend less money on buying Treasury bonds and lend more to private sector. (If treasury yields fell to 0%, it is less attractive to buy bonds)
  • The Federal Reserve are also trying to improve the balance sheet of banks by buying 'toxic assets' - mortgage backed securities which currently have little market value.

If successful, this will create inflationary expectations (rather than deflation), encourage lending and therefore encourage economic growth.

Problems With This Scheme

  1. The Federal Reserve are increasing the monetary base, there is a danger this could lead to high levels of inflation, when the velocity of circulation picks up.
  2. Increasing quantity of US dollars and reducing interest rates on bonds is likely to reduce value of dollar, so dollar is likely to fall.
  3. US National Debt is over 73% of GDP and is increasing all the time. This relies on people being willing to buy bonds and finance the debt.
  4. The worry is that lower interest rates and a falling dollar, will discourage foreign investors from holding US treasury bills and bonds. Then the US would struggle to finance its national debt. This would then cause either inflation (potentially very high) or an increase in interest rates to attract savers.
A key issues is whether:
  • Investors retain trust in the dollar
  • The US government's credit worthiness - If people feared US government could default this would create real problems for the US dollar and US deficit.

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