Forecasting a Speedup in Growth, the Fed Again Cuts Bond Purchases
Quantitative Easing Program of Federal Reserve Bank:
The article discusses the decision of the Federal Reserve Bank to taper the bond buying program and its effect on the US economy recovery and its other macro-economic decisions. The Federal Reserve took the much expected decision to cut down the bond buying program by another $10 Billion a month, restricting the bond purchase activity to $45 Billion a month from May, 2014. In response, the Federal Reserve declared that it was looking past the economic slowdown during an unusually cold winter because growth already was rebounding and with growth activity picking up in the economy, the decision was in the interest of the US economy functioning.
Economic Insight:
Such decisions by Federal Reserve Bank impose a great effect on the economy and are known as Quantitative Easing method in the economic literature. Quantitative Easing is a conventional and most commonly used monetary policy by the central bank to control the money supply in the economy. Similarly, here also, the Federal Open Market Committee said that the growth in the economy was witnessed after having slowed sharply because of the harsh winter conditions in the first quarter of the year and thus, the decision to taper the bond buying program was in the interest of the economy. Hence, in order to assure that with the economic growth and relaxed monetary policy, the economy do not gets trapped in the evils of inflation; Federal Reserve tapers its bond purchasing activity so as to restrict the money supply available in the economy. Important to note that such actions by the Federal Reserve have a direct impact on the size of the monetary base available in the economy. The diagram below explains the process of quantitative easing when the economy is experiencing growth:
Money Supply
Demand for Money
The above diagram indicates that at times of economic growth and in order to curb inflation and ensure sustainable growth in the economy, Federal Reserve reduces it demand for government bonds. This pushes the money supply curve backwards, resulting in reduced money supply in the economy and higher equilibrium interest rates. Subsequently, the credit turns expensive because of higher equilibrium interest rates and the economic activity is negatively affected as borrowers turns reluctant to borrow funds at increased rate of interests.
Discontinuation of 0% short term interest rates:
In the succeeding section of the article, the author discusses that although the Federal Reserve has declared their decision to taper the bond buying program, however, there is no reference to its decision over raising the short term interest rates, which has remained at the level of zero since the recessionary period of 2008. Important to note that interest rates play a major role in the functioning of the economy and if the Federal Reserve decides to end the 0% short term interest rates, it will have significant impact on the economy and the same is discussed below:
Economic Insight:
Interest rates are key drivers of the economy and with short term interest rates likely to be increased by the Federal Reserve, it will have significant impact on the US economy. Since the advent of economic crisis in 2008, the policy of the Federal Reserve to keep the short term interest rates has been the key driver of the return to the investors in recent years and subsequently influencing whole of the financial market including bond performance. Hence, if the Federal Reserve will change its interest rate policy, it will have enormous effect on the US economy. For Instance, Fed declared the short term interest rate in the range of 0% to 0.25% during 2008, so as to help the economy come out of recession and to ensure that the banks earn sustainable spreads between the rates at which they could borrow and lend money. The Fed has thus kept rates in the 0-0.25% range since that date, based on its belief that the U.S. economy would be unable to sustain positive growth without continued central bank stimulus. The diagram below will suitably explain the inverse relationship between the interest rates and bond prices:
90 Supply 11.1%
85 17.6%
80 25%
Demand
Quantity of Bonds
Hence, from the above figure we can figure out that with the fed approach of zero percent short term interest rates along with aggressive quantitative easing, which caused the bond yields to fall to historic lows, will end because with increase in interest rates this artificial demand will no longer sustain and bond yields will rise sharply with fall in their price levels. Overall, any increase in interest rates by Fed will depress the bond market performance.
Works Cited
APPELBAUM, BINYAMIN. Forecasting a Speedup in Growth, the Fed Again Cuts Bond Purchases. 30 April 2014. 19 June 2014 <http://www.nytimes.com/2014/05/01/business/fed-to-continue-cutting-bond-purchases.html?_r=0>.
Appendix:
WASHINGTON — The Federal Reserve continued to retreat from its stimulus campaign on Wednesday, saying it was looking past the economic slowdown during an unusually cold winter because growth already was rebounding.
As expected, the Fed announced after a two-day meeting of its policy-making committee that it would pare its purchases of Treasury and mortgage-backed securities by another $10 billion, to $45 billion a month beginning in May.
“Growth in economic activity has picked up recently, after having slowed sharply during the winter in part because of adverse weather conditions,” the Federal Open Market Committee said in a statement announcing the unanimous decision.
The statement, while affirming the Fed’s intent to stop buying bonds later this year, offered no new insight into the next decision the Fed must make: when to start raising short-term interest rates, which it has held near zero since December 2008.
There was, however, a hint that the Fed’s deliberations were more interesting than its declaration. The Fed also said on Wednesday that its board held an unscheduled meeting Tuesday morning to discuss “medium-term monetary policy issues.”
The last such meetings, in 2011, were followed by an announcement of the Fed’s plans for the retreat that is now in progress. Officials have said that some adjustments are necessary, and analysts said they expected more information on the discussions in an account of the meeting the Fed will release in three weeks.
The Fed’s chairwoman, Janet L. Yellen, said in a recent speech that the Fed was focused on three issues in determining how much longer to suppress interest rates, and how quickly to return rates to a level closer to the historical norm. She named the extent of slack in the labor market, the sluggish pace of inflation, and the chances that growth would be undermined by unexpected events — as has happened repeatedly since the end of the Great Recession, and most recently during a season of freezes and snowstorms that chilled buying and selling across a broad swath of the country.
The Fed has largely discounted the economy’s slow growth during the winter months in charting its retreat. The government said on Wednesday that the economy grew just 0.1 percent during the first three months of the year. Officials have concluded the slowdown was largely a result of the unusually cold weather.
“The main takeaway from this report is simply that the Fed continues to feel confident about the economic recovery, notwithstanding the disappointing growth performance” in the first three months of the year, Millan Mulraine, deputy head of United States research at TD Securities, wrote in a note to clients Wednesday.
Markets showed little interest in the Fed’s latest statement, which was largely the same as the statement the policy committee released after its last meeting in March.
“Nothing to see here,” was the summary offered by Barclays Capital.
The committee has reduced monthly bond purchases by $10 billion at each meeting since December, reducing the volume of purchases to $55 billion in April from $85 billion each month last year. It is on pace to end the purchases with a single cut of $15 billion when the policy committee meets in October, or a final cut of $5 billion in December.
It has been less clear about what happens next. Indeed, officials decided in March to preserve some ambiguity about the timing of a first increase in interest rates, substituting a vague description of economic goals in place of a commitment to wait at least as long as unemployment was above 6.5 percent. The Fed also has left some uncertainty about its plans for its bond holdings; its portfolio has swelled fourfold to more than $4 trillion since the financial crisis.
“Tying the response of policy to the economy necessarily makes the future course of the federal funds rate uncertain,” Ms. Yellen said in a recent speech explaining the change. “But by responding to changing circumstances, policy can be most effective at reducing uncertainty about the course of inflation and employment.”
The Fed has failed since the Great Recession to achieve its stated goals both for inflation and employment, and it is likely to be reminded of those failures in the coming days. The government will provide a new estimate Thursday of the Fed’s preferred measure of price inflation, followed Friday by the April jobs report.
Yet Ms. Yellen and other officials forecast that the Fed’s current policies would return both to healthy levels by the end of 2016.
The official unemployment rate stood at 6.7 percent in March, well above the minimum sustainable level, which the Fed estimates as between 5.2 percent and 5.6 percent. But officials have expressed satisfaction with the trend of declining unemployment, even as they acknowledge it most likely overstates the health of the labor market. The government counts people as unemployed only if they are actively looking for work, and many people without jobs have stopped looking for new ones.
In the weeks before this meeting, some Fed officials instead emphasized their concern about the slow pace of inflation. The Fed’s preferred measure increased just 1.1 percent over the 12 months through February, well below the Fed’s 2 percent annual target, although the Fed continues to forecast that inflation will rebound as the economy recovers.
