In a surprise response to what it sees as a worsening economic landscape, the Federal Reserve yesterday added over one trillion dollars to its balance sheet by buying government and agency mortgage-backed securities. Stock markets, gold, bonds and oil rallied and the dollar lost value.
If you have an interest in economics and finance, you might wonder what the Fed is trying to accomplish by this and a host of very aggressive moves that will ultimately get credit flowing, jump start he economy and keep interest rates low. Here is the quick version:
When the Fed buys bonds it must pay for them. That money is then deposited in bank accounts providing more cash for those banks to invest. The hope is that all that excess cash above what banks are required to keep as reserves will find its way into the system, primarily through the banks' normal lending practices. Of course, this assumes those very banks have figured out who they should be lending to--how much risk they should take. If they can, then we may see some semblance of business as normal.
Unlike other short term fixes the Fed has at its disposal, bond can remain on the Fed's balance sheet for a long period of time. This means that all that cash will not be removed until the Fed feels the banking system and the economy is off and running. After all, selling those bonds would remove dollars from the system. Buying bonds also affects long term rates, something that the Fed doesn't normally do. It is considered a very strong move. Lower long term rates make it easier for businesses to borrow in the capital markets. By buying agency mortgage-backed securities, the Fed, in essence, removed mortgages from banks balance sheets and replaced them with cash. This should help free up mortgage money as well.
The investments that benefit in the short term are those that anticipate not only a recovery but a return of inflation. No one at the Fed is worried about inflation right now. Stocks benefit because inflation is a better alternative than deflation (general prices dropping). Gold loves any world economic crisis including runaway inflation. Bonds do not like inflation at all but must adjust to the fact that the Fed is now a major buyer and all those bonds President Obama must sell will be purchased by another government entity. The dollar loses both short and long term since we have a fiat currency and the only backing for each greenback is the hope and prayer that someone will accept it for payment. Inflation erodes the dollar's purchasing power. The positive here is that our exports become cheaper, and there are world economies like Vietnam, Malaysia and Singapore which are expected to post healthy growth this year. Our products and services become more competitive in the world market.
For additional information on all Fed activities, go to www.federalreserve.gov
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