Market fever focuses on Fed's future plans as US struggles
MARKET excitement over what the Federal Reserve will do to help an ailing US economy has more to do with what it might do in the future than with Tuesday night's announcement.
The dollar rose, and the rate investors will accept for lending to the US government fell to an 18-year low, after the US central bank said it would maintain the size of its balance sheet at around $2 trillion (€1.5tn). A curious cause for excitement, one might think, and several analysts would agree.
But the alternative -- reducing that unimaginable figure of $2 million millions -- would have put some upward pressure on interest rates. The Fed's Open Market Committee (FOMC) believes the US economy is not ready for that.
"The pace of recovery in output and employment has slowed in recent months," the FOMC said in its statement yesterday. It also repeated its promise to keep interest rates low "for an extended period".
That means zero to half a per cent for short-term rates. But that medicine is not proving sufficient. Like other central banks, the Fed has been creating new money in the economy by buying assets from the banks, particularly mortgages wrapped together as tradeable securities. These assets now belong to the Fed, bringing the value of its balance sheet to $2.3tn (€1.7tn).
In 2007, the balance sheet was less than $900bn. The $1,200bn (€932bn) difference is one measure of the monetary stimulus that the Fed has delivered. But as those securities came due for repayment, the money would have flowed back from the banks to the Fed vaults. That was the original plan, but the risk of deflation as this cash left the money supply is seen as too great. Now the idea seems to be that the Fed will use this cash to buy US government bonds -- known as Treasuries. But that is pretty much steady as she goes.
The market reaction seems to be that, having apparently signalled a willingness to buy Treasuries, the Fed will do so if it feels the system needs more stimulus. The printing press is primed and ready.
The Bank of England took a similar view yesterday. Its optimistic forecast of 3.5pc growth in the UK next year is being scaled back to 3pc. At the same time, UK inflation may not get back to the 2pc target until 2012. But, says the bank, it will come back, because the economy is too weak to sustain rising prices.
Markets think the UK central bank may also return to buying assets, having completed the previous programme a few months ago.
The ECB's rhetoric is different. President Jean-Claude Trichet is still fairly upbeat about the eurozone's prospects, but the central bank has also felt it too dangerous to reduce its lavish support for the banking system, or increase the short-term rate in money markets even to the official level of 1pc.
Some may feel we have been here before. The Fed in particular has rescued the markets from every crash and downturn since 1987. That may be one reason why this one is so gargantuan and difficult to fix.
Central banks and governments are right to try to avert depression and deflation. But at some point, private banks and households must address their own debt problems or the seeds of even greater trouble may be sown.