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Fed operates printing press

Fed operates printing press
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First Published: Thu, Mar 19 2009. 09 45 PM IST

Illustration: Jayachandran / Mint
Illustration: Jayachandran / Mint
Updated: Thu, Mar 19 2009. 09 45 PM IST
The printing presses have started rolling in earnest.
Ever since the US Federal Reserve brought down its key policy rate to zero in December, it was evident that the limits of traditional monetary policy had been reached. Central banks usually cut nominal interest rates to spur demand in a recession. But American interest rates cannot go below zero—which would essentially mean that savers pay banks to keep their deposits, a highly unlikely arrangement.
Illustration: Jayachandran / Mint
So it was clear much before the Fed’s monetary policy group met on Wednesday that US interest rates would not be touched. The only alternative: quantitative easing, a fancy phrase for printing money.
The Fed has now decided to buy $1 trillion of various long-term government and mortgage securities in a bid to bring down borrowing costs, especially for homeowners. These purchases will ensure that the size of the US central bank’s balance sheet touches $3 trillion, more than thrice what it was in September.
A central bank usually buys and sells short-term securities to manage liquidity in the money market, and this perhaps is the first time in 50 years that the US Fed will buy long-term securities.
A central bank pays for the securities it buys by printing new money. That is precisely what the US Fed will do. These are unusual times in the world economy. Central banks have good reason to try out unconventional measures, especially since the textbook measures have more or less failed to stem the troubles in the economy.
But there are two significant risks that the US Fed will now have to face.
First, pumping huge amounts of fresh money into a shrinking economy could lead to a fall in the external value of the currency and increase inflationary expectations. You do not have to be a monetarist to realize that extra money supply can destroy the value of a currency, either against other currencies (devaluation) or against a basket of goods (inflation).
Second, the current recession across the world has its roots in the financial sector. The core business of banks and financial institutions is to borrow short and lend long. So a large difference between short-term and long-term interest rates can help banks stem losses. But the new Fed move to buy $1 trillion of long securities is likely to bring down long-term interest rates and flatten the yield curve. That’s bad news for global banks.
Is printing money a viable long-term option? Tell us at views@livemint.com
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First Published: Thu, Mar 19 2009. 09 45 PM IST