Don’t fight the Fed

Updated: Feb 15


When COVID-19 struck, the Federal Reserve (Fed) stepped in to try to avert economic crisis. As the US central bank continues to pump billions of dollars into the financial system daily, who is benefiting and at what cost?


Biggest player in the financial market has been Fed and all the recent moves can be predominantly attributed to it. No one can fight with Fed as it has unlimited capacity to print currency (USD) which is world’s reserve currency.


Game started in the Global Financial Crisis (GFC) of 2008-09 when Fed did quantitative easing to calm the financial markets and stopping them from going into the coma stage. Quantitative Easing wasn’t ever tried before so the consequences were unknown.


What is Quantitative Easing?


Quantitative easing (QE) is a form of unconventional monetary policy in which a central bank purchases longer-term securities from the open market in order to increase the money supply and encourage lending and investment. Buying these securities adds new money to the economy, and also serves to lower interest rates by bidding up fixed-income securities. It also expands the central bank's balance sheet. Federal Reserve bought government securities and mortgage backed securities in the GFC.


What happened in COVID-19?


The coronavirus crisis in the United States—and the associated business closures, event cancellations, and work-from-home policies—triggered a deep economic downturn of uncertain duration. Fed stepped in with a broad array of actions to limit the economic damage from the pandemic, including up to USD 2.3 trillion in lending to support households, employers, financial markets, and state and local governments. “We are deploying these lending powers to an unprecedented extent [and] … will continue to use these powers forcefully, proactively, and aggressively until we are confident that we are solidly on the road to recovery,” Jerome Powell, chair of the Federal Reserve Board of Governors, said in April 2020.


Fed restarted QE (similar to GFC) with purchase of government securities and mortgage backed securities. This seemed partly reasonable as it was needed to calm the financial markets. However, Fed went a step ahead and lend directly to corporate by buying new bond issuances and providing loans. Did Fed overstep its mandate?


Moral Hazard


QE artificially depresses the cost of borrowing. Normally, governments or any other institution issuing additional debt see their borrowing costs rise, which discourages them from overdoing it. In particular, market discipline in the form of higher interest rates will cause a government or any other institution, tempted to increase deficit spending, to think twice. Not so, however, when the central bank acts as bond buyer of last resort and is prepared to purchase securities without limit. In such circumstances, market discipline will be incapacitated.


QE is like an anti-biotic which works best in 3 day or 5 day courses.. no doctor recommends taking anti-biotic for a long duration. But, Fed is still continuing after more than 18 months and is now begging to taper off. Please do read our article of Taper Tantrum which will be published shortly.


Fundamental principle of capitalism is entrepreneurship or risk taking – some ventures or ideas succeed and many fail. Fear of failure puts a cap on the amount of risk taking (Greed). However, when the Fed is giving a guarantee on the downside, the market participants go for broke due to uneven pay-offs. It has created bubble in all markets – equity, bond, housing and crypto!


In Hindu tradition, Brahma is the creative force, Vishnu the preserving force and Mahesh the destroyer. Dharma is served well when all the three are in balance and alignment, aligned in our words and deeds, that is. In the modern world, Brahma is about creativity and innovation, Vishnu about preservation and well-being, and Mahesh the creative destroyer. In capitalism, we can think of them as:


  • Brahma – entrepreneur starting new business

  • Vishnu – government or central bank creating environment for the business or economy to operate

  • Mahesh – market forces like competition or change in customer behaviour kills businesses


All three need to be in balance for the capitalist economy to function. With Fed going for QE, the balance has been disturbed.


What are the consequences?


Your guess is as good as ours.


Do see this video to understand more on Fed and QE!!!


 



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