Why The Fed is Buying US Bonds

The Federal Reserve have announced a plan to buy $75 billion of US Treasury bills each month up to a total of $600bn by end of 2011.

The Federal Reserve are worried about the US recovery. Though, the US has officially left recession, there are signs that the economy remains depressed and below full capacity.

• Unemployment is stubbornly high (just below 10%)
• House prices continue to be weak.
• Low income growth
  
• Still continued signs of disinflation (Falling inflation rate, below US target)

The Federal Reserve have indicated the desirability of fiscal stimulus (e.g. public works spending) however, given the state of US congress, this is unlikely to materialise. With short term interest rates close to 0%, conventional monetary policy doesn't offer many options.
Therefore, the Fed are proposing to buy more long term dated government bonds through the policy of quantitative easing (electronically creating money)

Impact of Buying US Treasuries

• Buying long term bonds will drive down interest rates on government bonds. This fall in bonds should also help decrease interest rates on corporate bonds.
• Lower interest rates on corporate bonds should help boost investment and spending, leading to stronger economic growth.
• Increased Money supply should help combat the deflationary pressures in the economy. By buying treasury bonds off banks, they in turn have more liquidity to lend to business.
• Increasing money supply and purchase of US treasuries weakens the US dollar. A weaker dollar makes US exports more competitive helping boost exports and reduce imports.

Potential Problems of Policy

• Some economists argue the round of Quantitative easing is too small as a % of the economy. Without changing public expectations of inflation, the US recovery may continue to be too slow.
• Monetary Policy is not a magic tool. Reducing interest rates on government and corporate bonds may be insufficient to induce lending, when confidence and effective demand is not there.
• A more effective combination would be fiscal policy and quantitative easing. Higher government spending on public works scheme would help inject demand into economy and give firms a greater incentive to borrow and invest.

On the other hand, other economists worry about policy from opposite point of view. For example,

• By weakening the dollar, the US risks alienating investors in US assets. People could fear the dollar is not reliable as a safe investment like in the past.
• By increasing money supply and weakening the dollar, there is the prospect of increasing long term inflationary pressure.
• By artificially reducing interest rates, the Fed may be encouraging an increase in unsustainable borrowing and cause a misallocation of resources in the economy. It may lead to an asset bubble.

Related

• Printing Money and inflation
  
• Quantitative easing
  
• US Dollar collapse