Fed monetary stimulus struggles to fight out of liquidity trap

a mousetrap, baited with a wadded up dollar bill

The Fed's latest monetary stimulus seeks to jump start the economic recovery by avoiding a liquidity trap. Think Stock photo.

The Federal Reserve is experimenting with the money supply in an effort to bring a flagging U.S. economic recovery back on track. To keep interest rates that are already near zero down, the Fed is taking interest from its vast pool of mortgage-backed securities and buying U.S. Treasury notes and bonds. This practice, called monetary stimulus, or quantitative easing, injects cash into the public market. The theory is that by expanding the money supply through monetizing debt, interest rates decline. Businesses and consumers will want to borrow and spend more, because savings essentially earns no interest.

Fed’s monetary stimulus: deep concern about economic outlook

An earlier round of monetary stimulus during the economic downturn seems to have failed to spark a sustainable recovery. Reuters reports that the second round of quantitative easing, dubbed QE2, is the most important monetary policy announcement for the Fed since it first revealed its intention to buy assets in late 2008. The announcement of QE2 has had a short-term effect exactly opposite of its intent. Another round of monetary stimulus sends a signal that the Fed is deeply worried about the fragile state of the economy. The announcement fueled a sense of doubt in markets. Stocks plunged. Talk swirled of Japanese-style deflation, where no amount of monetary stimulus is enough to jump-start economic growth.

Fed rolls the dice with QE2

The Fed’s monetary stimulus is a risky move, according the The People’s Voice. To avert the worst of the housing crisis, the Fed purchased more than $1 trillion in Fannie Mae and Freddie Mac securities to push mortgage rates to record lows. Fed officials wondered publicly how to get rid of these securities. With economic recovery going south, they have concluded they can’t without forcing mortgage rates back up again. Meanwhile, the Fed collects billions in principal and interest on this portfolio. Using the cash to monetize debt is loaded with risk. The housing market could very well weaken further and foreclosures could rise. If, and some say when, that happens, the Fed will be sitting on billions of dollars of credit losses on its portfolio.

Caught in a liquidity trap

The Fed’s latest monetary policy move makes sense on paper in a textbook economy. But Daniel Indiviglio, writing in the Atlantic, said that it relies on the assumption that demand will rise to meet supply. Interest rates are already very low, yet businesses continue to sit on cash because they aren’t convinced that the demand will exist in the near-term to expand. Consumers are paying down their debt and saving for an uncertain economic future. These conditions are what economists refer to as a liquidity trap. No matter how low the Fed pushes interest rates, it won’t help economic recovery because no one wants to borrow.

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