Interest Rate Roundup

Wednesday, November 26, 2008

Feds Gone Wild!!

Forget those tacky "Girls Gone Wild" movies. We're watching a better movie these days -- "Feds Gone Wild." The government and the Federal Reserve have now managed to rack up a whopping $7.8 TRILLION in obligations fighting the credit crisis. That includes direct bailouts, guarantees, loan commitments, and other liabilities. The Fed is also rapidly barrelling down the path to quantitative easing -- essentially printing money out of thin air to fund bailout after bailout.

Risk is extremely high here. Policymakers are trying to fight the "Japan in 1990s" scenario where twin busts in stocks and real estate led to a Lost Decade of dismal economic performance. But at the complete other end of the spectrum is the Weimar Germany scenario, where rampant money printing leads to hyperinflation and a currency collapse.

The Fed and Treasury clearly believe they can thread the needle, providing an abundance of stimulus now, then withdrawing it later before a real inflation problem sets in. Americans better hope they're right. More from the New York Times below ...

"But the new programs also represented a new level of commitment by the Federal Reserve. Instead of trying to strengthen the economy by reducing short-term rates, which is the usual policy tool, the Fed is now pumping vast amounts of money directly into specific markets for mortgages — and anything else it believes needs help.

"Over the last year, the Fed and the Treasury have bailed out major Wall Street firms, rescued the world’s biggest insurer, taken over Fannie Mae and Freddie Mac, and guaranteed hundreds of billions of dollars in bank transactions.

"As big as the two new lending programs are, Mr. Meyer cautioned that they were only going to reduce the pain that lies ahead, not eliminate it. Unemployment, at 6.5 percent in October, is still likely to climb to 7.5 or even 8 percent next year, he predicted. But it may not shoot up to 9 or 10 percent, a level that economists often consider the unofficial dividing line between a recession and a depression.

"The new actions are unlikely to be the last. Until the economy begins to turn around, Fed officials have made it clear they are prepared to print as much money as needed to jump-start lending, consumer spending, home buying and investment.

“They are using every tool at their disposal, and they will move from credit market to credit market to reduce disruptions,” said Richard Berner, chief economist at Morgan Stanley.

"The Federal Reserve has now moved to a radical new phase of its effort to shore up the economy. Until now, it has carefully distinguished between two goals — reducing the panic and turmoil in financial markets, and propping up the economy itself, which has been battered as the supply of credit has dried up.

"To tackle the first goal, the Fed expanded its lending programs to banks and Wall Street firms, and organized the rescue of failing firms like Bear Stearns.

"To bolster the general economy, it relied on its traditional tool: reducing the overnight Federal funds rate, the interest rate that banks charge for lending their reserves to one another.

"Normally, a lower Federal funds rates leads to lower long-term rates, like those for mortgages.
But the central bank has already lowered the rate to 1 percent, and it cannot reduce it below zero. Instead, policy makers are buying up other kinds of debt securities, which has the effect of driving down the rates in those parts of the market.

"The move amounts to what economists refer to as “quantitative easing,” which means having the Fed pump staggering amounts of money into the economy by buying up a wide range of debt instruments.

"In a conference call with reporters, Fed officials insisted their goal was not to pursue a policy of quantitative easing, but simply to unfreeze the mortgage market.

"But for practical purposes, the actions lead to similar results."


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