Thank goodness that I am surrounding by normal people, like Will from Louisville, KY who listens to my interviews on WHAS with Tony Cruise. While I was parsing the Federal Reserve's FOMC statement yesterday, Will sent me a great question: "What does it mean when the Fed buys $600 billion in government bonds...Maybe you can explain what all that means to us common people."
Will and everyone else, here's what you need to know about the Fed's $600B shopping spree:
Image by Flickr User rychlepozicky.com, CC 2.0
- What's the Fed doing? The Fed will purchase $600 billion worth of long-term US government bonds, starting with $75 billion dollars a month. If you want to sound cool/geeky, you can throw around the term "quantitative easing" or "QE2" to describe the Fed's action. The added benefit is you can say "QE2 is setting sail," which is not original, but at least there's a visual.
- Where does the money come from and where does it go? The Fed prints money and then the Federal Reserve Bank of New York actually buys the bonds on the open market. The seller of the bonds now has the Fed's money, which will be used to buy something or be deposited into the banking system.
- Why is the Fed acting? If you hadn't noticed, because you are either (a) a delusional banker who is only concerned with your looming bonus or (b) have been sequestered in some far-away place, the US economic recovery is not going so great. With unemployment at 9.6 percent and total growth at a sub-par 2 percent, the Fed is hoping to inject a little life into the economy.
- How does bond buying help the economy? There are two effects of the bond-buying: interest rates stay low and more money is sloshing in the system. (For more on how bonds work and to see one of my very bad hair days, go here). The Fed hopes that its shopping spree will lead to three outcomes that will boost the economy: (1) banks will lend the near-trillion dollars they hold in excess reserves (2) consumers will borrow and spend more freely (3) companies will gain confidence and use the cheap money to increase capital spending or to create jobs.
- Will it work? It's not clear. Critics say the banks are already sitting on a pile of money; consumers are busy digging out of the hole and are not about to change course; and uncertain companies are not likely to make any big expenditures until demand picks up.
- Why are stocks rising? If nature abhors a void, so too do institutional investors (hedge, pension and mutual funds). When cheap money floats around the system, lots of these sophisticated investors borrow it and then invest the proceeds in assets that they believe will rise, like stocks. This is fondly known as "the reflation trade" and it has reaped short-term gains a bunch of times over the past decade, only to explode, once rates rise.
- Is there a downside? As noted above, cheap money has fueled asset bubbles in the past (remember that pesky housing bubble?). Beyond that, many fear that QE2 will shred the US dollar and lead to in inflation down the road.