America's big bail-out could backfire
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Associate Editor
David Stevenson Mar 19, 2009
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Welcome to the "Rambo Fed", says New York Mellon chief economist Richard Hoey.
Last night the US Federal Reserve blasted the bond market with a heavy-duty burst of financial ammunition. In a surprise move, it says it's going to buy $300bn (£215bn) of government bonds - as well as more than doubling its 'asset purchase programme' to $1.45 trillion.
In other words, America's following Britain's example in printing money like mad. But it's just about the US central bank's last shot in the locker to stop the global slump.
So will it work?
There's no doubt that "this is a very powerful and aggressive move" by the Fed, according to Hoey. And it certainly caught bond traders on the hop. Within seconds of the announcement, yields on ten-year Treasuries – US government bonds which mature in 2019 and a key bellwether of global long-term interest rates – plunged to 2.5% from 3%, the biggest drop since 1962.
Bond yields fall when buying pushes up prices. Here the market had to react very fast to a new, unexpected, and very large purchaser. And the net effect of all this asset buying will be to inflate the Fed's balance sheet "to something like $4.5 trillion", says Capital Economics, "equivalent to around one third of annual US GDP".
What does that all mean in plain English?
The Fed's move is copying the Bank of England's latest crank-up of the money printing presses – so-called quantitative easing (QE). These days, central banks don't physically create more dollar bills or pound notes, it's all done painlessly behind closed doors with an electronic ledger entry. But the result's much the same. By buying bonds, central banks increase the amount of money in circulation.
Now America's been dabbling away at other forms of QE for months, so maybe we should call this latest move 'QE II'. And we Brits have just started. But so far, most of the extra cash that's been created on both sides of the Atlantic has been either sloshing more slowly around the financial system, or has ended up in the vaults of banks that are technically bust because of all the dodgy loans they've made. Until they know the full extent of the damage done to their balance sheets from several years' ridiculously lax lending, they're hoarding what they can. That's what happened in Japan (as our regular writer James Ferguson points out in this week's issue of MoneyWeek, out tomorrow – get your first three issues free here).
Which is why QE, or indeed any of the politicians' "initiatives" or "stimulus packages" haven't done the trick in stopping the slump. In fact, by creating panic, they could well have made matters worse.
But ultimately, if the central banks create enough new money, some of it is bound to have an effect on the real economy. Banks may not want to lend, but there are eager takers for the cash in the form of governments. The latter are now so desperate to be seen to be doing something that will at least temporarily halt the economic slump, they'll spend "whatever it takes". In essence, governments will run up huge deficits and so will need to borrow lots more, while their central banks will print the money to fund them.
All sounds very cosy. But there are two massive snags.
First, too much extra money being printed will eventually just push consumer prices up too fast again, as we pointed out last week: (Why printing money must lead to inflation). And there's a risk that QE II "might be a step too far", says Simon Ward at New Star, if it leads to over-rapid money supply expansion which "isn't desirable for medium term inflation and market stability".
And second, central banks' bond buying is creating a false price and yield level for government bonds. But the amount of government debt that will need to be sold over the next few years - so many trillions it's hard to envisage - must inevitably force up ten-year bond yields from their current artificially low levels.
So long-term interest rates will have to rise sharply. There's a real danger that could choke off any economic recovery before it really starts, as global borrowing costs are forced up. In short, QE II could backfire badly.
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