Tuesday, May 26, 2009

Buying US Treasuries

Since March the US Federal Reserve has been buying US Treasuries by effectively creating money. The aim of this unorthodox monetary policy is:
  1. Reduce yield (interest rate) on government bonds. The lower interest rates may encourage banks to lend rather than hold US treasuries. Also lower interest rates also help the government reduce the cost of servicing the debt.
  2. Provide Monetary stimulus. By buying US treasury bonds from banks, banks will see an increase in the money supply and in theory will lend to private business and consumers. With a money multiplier this could be quite a large monetary stimulus. Because of the scale of the recession many fear deflation. Therefore increasing the money supply helps to prevent deflation becoming a problem.

Problems of Buying US Treasuries.

Inflation. Creating money to buy US treasuries has the capacity to cause inflation. At the present time the policy is not causing inflation because the falling velocity of circulation means that the increase in the money stock is not currently inflationary. However, in the future, the increased money stock has the capacity to cause significant inflation For more details see: Money Supply US

Foreigners Increasingly Nervous of Holding US debt. 23% of US government debt is held by China and Japan. The US need to raise another $2 tn for this fiscal year. They will be hoping foreigners keep buying US debt. But with the policy of increasing money supply, there is risk of devaluing dollar through inflation. Therefore, buying US debt could see a fall in the value for Chinese and Japanese investors. Recently both China and Japan have become nervous over the scale of US quantitative easing. (see: China warns US)

There is no sign of foreign investors wanting to dump dollar treasuries. It is not in the interest of China and Japanese investors to see a sharp devaluation in the dollar. But, the world's appetite for buying bonds is quickly falling.

Updated post on Fed buying US Treasuries

see also: quantitative easing Policy in US


supernova said...

I have a question about point 2 in your once again excellent post.

As most banks free trade on a worldwide basis (globalization), there is a more than fair probability that the money will be invested in other countries outside the US if this brings better returns on investment for the banks.

In other words the cash injection may not result in a good money multiplier effect for the US since the lending may leak into foreign lands.

As such buying back US treasuries is inefficient if the objectives is to try and control/reduce US unemployment.

Is this a fair analysis?

Michael Moore said...

Should the figure in "Foreigners Increasingly nervous of Holding US debt" be $2bn (or $2m) rather than $2?

Tejvan Pettinger said...

thanks Michael!

Supernova. There will be some leakage from US economy. This just means the intervention will be less effective in boosting US demand. This will require a bigger stimulus to be effective. But, on the other hand the creation of credit could create its own multiplier effect.