Sunday 21 December 2008

**Desperate times: how the Fed plans to save the world

Economic policy
Desperate times: how the Fed plans to save the world
Larry Elliott, economics editor
The Guardian, Thursday 18 December 2008

The unusual measures unveiled this week by the Federal reserve chairman, Ben Bernanke, promise to usher in an era of free money unprecedented in the history of financial markets. They include tools designed to lower long-term interest rates and boost growth in the world's biggest economy. Here we look at what the measures are, what they mean for you, and what will happen if they don't work.
Why has the Fed been forced to take such drastic steps?
After 18 months in which they have cut interest rates sharply, nationalised leading banks and provided tax rebates for consumers, US policymakers are now desperate to halt America's slide into a deep and painful recession. For historical reasons, fear of a slump runs as deep in the US as does fear of inflation in Germany, but all the conventional policy tools have so far failed. Non-farm jobs fell by more than 500,000 in November, the biggest drop since the mid-1970s, and the housing market is in freefall. Ben Bernanke is a former academic who specialised in the lessons of the Great Depression, one of which is that policymakers have to act fast and decisively to prevent a deflationary spiral setting in.
So what is the Fed proposing?
There are various forms of interest rates. Policy, or short-term, rates are set by central banks and affect the cost of money to the financial system. In the UK, the policy, or bank rate, is 2%. In the US, after Tuesday's cut, the Fed has set a target range of 0% to 0.25% - an all-time low. In normal circumstances, ultra-low policy rates make it easier for banks to lend money to their business and personal customers but these are not normal circumstances. The supply of credit has dried up as banks repair the damage to their balance sheets caused by losses on their ill-judged investments during the boom. Real borrowing rates for households and firms have fallen but not nearly so rapidly as have policy rates. The Fed's actions this week are aimed at cutting real borrowing costs.
How does it do this?
The Federal Reserve has already bought up mortgage-backed securities and the debts of Fannie Mae and Freddie Mac, the two giant state-owned mortgage finance companies. This week it said this programme would be stepped up and perhaps extended to purchases of longer-term treasury securities. Buying treasury bonds, the remedy proposed by Keynes in the 1930s and taken up by Franklin Roosevelt, is a radical step and as yet only being "evaluated" by the US central bank. But its aim is to drive down the long-term interest rates, normally set by buying and selling in the financial markets, through large-scale purchases of bonds. The interest rate - or yield - on bonds goes down as the price goes up, and buying bonds makes them more attractive by reducing the supply. Bringing down the interest rate on long-term bonds also brings down all other long-term interest rates, on fixed-rate mortgages, for example. It also gives the banks more money to lend because they exchange their bonds for money from the central bank.
So what's the drawback?
This process, known as quantitative easing, involves a huge expansion of the central bank's balance sheet so it can buy the bonds. It is not "printing money" since it no extra banknotes are churned out, but it gives the commercial banks more capital to lend on to their customers. To be effective, the central bank has to reassure financial markets that it will hold down long-term interest rates for as long as it takes to get credit markets working again. This means expanding the money supply, with the risk of re-igniting inflation once growth picks up. Bond markets are traditionally terrified by inflation and if investors start to believe that the central bank has lost control, a bond market bubble could potentially turn into a bond market bust.
What happens if it doesn't work?
In those circumstances, the next step will be wholesale use of fiscal policy. Keynes said in his General Theory that there might be cases when spirits in the private sector were so low that there would be no desire to borrow at any level of short-term or long-term interest rates. The state would then try to boost activity itself, either by public works or tax cuts. President-elect Barack Obama's plan for a fiscal boost worth 4% of GDP is an acceptance that quantitative easing might not be enough.
Anything else?
The economist Milton Friedman once said it would be theoretically possible for policymakers to end a depression by dumping wads of cash on the populace below from helicopters. This was cited by Bernanke in a paper in 2002, winning him the nickname Helicopter Ben. Other "unconventional" suggestions include providing consumers with time-limited spending vouchers that would force them to spend, or even making people pay banks for holding their money.
What does it mean for the UK?
The Bank of England and the Treasury are looking at whether quantitative easing would be possible in the UK. The upside would be that mortgage rates, overdrafts and business finance costs would fall if long-term interest rates declined. The downside would be if the markets became alarmed at the risks to inflation, turning the recent run on the pound into a full-blown sterling crisis. The pound does not have the dollar's reserve currency status so the UK is more vulnerable than the US.
Is there an alternative?
The other option is to do what the Austrian school of economists suggest: wait for the crisis to blow itself out. What is needed, they argue, is not shoring up a failed system but a period of creative destruction that will lay the foundations for stronger long-term growth. Politicians, who have elections to fight, find the do-nothing option somewhat unattractive.

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http://www.guardian.co.uk/business/2008/dec/18/federal-reserve-measures-ben-bernnake

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