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What exactly is the Fed trying to achieve

Written by A Forex View From Afar on Thursday, December 18, 2008

This week, the Fed announced in the FOMC statement that it will maintain expanding its balance sheet, through buying “large quantities of agency debt and mortgage-backed securities” and by open market operations. In the following article we are going to see what, exactly, the Fed is trying to achieve with this.

Having the inflation rate drop like a stone, from 5.6% to the current 1.1% in 5 months, the Fed fears the economy will face a deflationary period. The assets price will decrease, instead of following the normal uptrend, due to the scarcity of natural resources and/or due to the decline in the real value of money (which happens in a normal-working economy).

Generally speaking, deflation comes during recessionary times, although this has not always been the case. In modern times it is, because it shows that the money supply is shrinking due the credit crisis. In other words, despite the Fed’s auction to increase the money supply, the monetary base got thinner and thinner.

Until a few months ago, the Fed influenced the business cycle and the money supply by buying and selling Treasury notes. As we all know, these days, monetary policy has reached its limits, so now the Fed is trying to buy different classes of assets in order to lift their price.

For example, by buying mortgages, as it was said in the statement, the Fed shoots two rabbits with one bullet. It first increases the price for mortgage bills. Due to the reverse relationship between the price and the yield of a bond, yields drop, making mortgages more accessible. Secondly, it will increase the market liquidity, which pretty much dried out during the credit crisis. Thirdly, and more important, it will increase the price for various assets (houses for example) by stimulating demand, raising inflation expectations.

However, theory sometimes has little to do with reality. A similar approach was tried by the Bank of Japan in early 2000, but from my point of view, even now, the Japanese economy has not fully recovered.

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