published Wednesday, October 6th, 2010

Hopkins: Fed keeps rates on floor, tries to reflate economy

Q: I hear that the Federal Reserve is contemplating more quantitative easing. What does that mean?

A: Quantitative easing is the name given to the extraordinary actions taken by central banks such as the Federal Reserve System aimed at increasing the quantity of money to stimulate lending and promote job creation.

It generally entails purchases by the Fed of U.S. Treasury securities and other bonds in the open market with the intention of flooding the banking system with cash.

QE is a fall-back strategy that is employed only when more conventional interest rate manipulations have been exhausted.

Economies are inherently cyclical; alternating bouts of expansion (economic growth) and contraction (recessions) are normal and inevitable characteristics of free markets. Government intervention designed to attenuate cyclical extremes falls into two broad categories: fiscal policy (taxation and spending), and monetary policy (interest rates and the supply of money).

While fiscal policy is the responsibility of Congress, monetary authority resides within the Federal Reserve Board.

The biggest wrench in the Fed’s toolbox is the ability to influence the level of interest rates in the U.S. economy. In response to a typical downturn the Federal Reserve cuts the benchmark rate at which banks lend short-term reserves to each other (the “fed funds” rate), and the rate at which banks can borrow directly from the central bank (the “discount rate”).

Although there is always a time lag, lower borrowing rates stimulate demand for loans from business and individuals and impart forward momentum to the ailing economy. In a “typical” recession this type of intervention is gradually unwound by raising rates over time as growth becomes self-sustaining.

However, this recession has been anything but typical and has demanded stronger medicine. In 2008, the Fed began buying various assets in an effort to pump liquidity into the market.

During this first iteration of QE, the Fed’s portfolio of loans and bonds increased from $888 billion to over $2.2 trillion. Meanwhile, the target fed funds rate has been stuck at zero for over a year, evidence that the traditional policy wrench has not been big enough.

So, the central bank is considering bringing out the vice grips: another round of bond purchases, or QE2, to inflate the money supply. While the macro impact of additional quantitative easing is debatable, individual investors are likely to suffer even lower yields on CDs but benefit from further declines in mortgage rates.

Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Chris Hopkins is vice president, investments, at Barnett & Co. Inc. Submit questions to his attention by writing to Business Editor John Vass Jr., Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by e-mailing him at jvass@timesfreepress.com.

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