Will the Fed's New Monetary Stimulus Help?

Yesterday we learned that the Federal Reserve is so worried about the economy that it has decided to take further action to loosen monetary policy. In this case, it will use the cash from some of its maturing securities to purchase new longer-term Treasuries. The intent here is to keep longer-term interest rates down. Will it help?

The Theory

The usual supply-side argument for expansionary action by the Fed goes as follows. If the Fed buys debt, then interest rates will decline. Consequently, businesses and consumers will want to borrow more money to invest and spend, while they will be discouraged from saving because they'll earn so little interest on their money. This will result in more economic activity and the elusive recovery.

The logic makes sense, except that it relies on a very important assumption: demand will rise to meet supply. It might not. Even if rates are low businesses might continue to sit on cash, not because it's such a great deal to save, but because they aren't convinced that the demand will exist in the near-term to expand. Consumers may also be saving more and paying down their debt. Again, their intention is certainly not to take advantage of the low interest rates on saving, but to save for a more uncertain economic future and lower their future interest payments.

When this occurs a nation is in what economists refer to as a liquidity trap. That's when, no matter how low the central bank has pushed down interest rates, they doesn't help the economy because no one wants to borrow.

Applying It to the U.S.

At first, whether the U.S. is really described by last two paragraphs above was more controversial. As the financial crisis waned, and the economy began to come out of recession, it was clear that banks felt the need to pad their balance sheets, so they lent less. But at this point, it has become quite clear that businesses aren't that interested in loans for expansion. Recently, small businesses said that demand was a much bigger problem than loan availability. Interest rates are also very low, so obviously consumers can't be saving because they're exited about that return.

How does the Fed hope to fix the problem with its latest policy move? It's targeting the purchase of longer-term debt, to drive down long-term interest rates. A liquidity trap is generally a problem when only short-term rates are kept low. Since most people assume that things will be better in a year or two, their short-term investment might not provide the capital needed to repay a loan over that time period. But by driving down long-term rates, perhaps the Fed can stimulate longer-term borrowing, since more people will assume that the U.S. economy will look better in two to nine years, at worst.

Will It Work?

A liquidity trap is mostly about expectations. So whether or not this works depends on sentiment. If it's bad, but not terrible, then we'll start to see longer-term investment picking up. If a business thinks that demand will rise in three years, for example, buying some new equipment with a 10-year loan at an ultra-low rate might seem like a good decision. But if sentiment is truly terrible, and businesses think we're in for a decade of high unemployment and ultra-low consumer demand, then even low longer-term interest rates won't help.

On the consumer side, the Fed's logic seems less plausible. The interest rates that its latest move would have the most effect on are mortgage rates. They hit another new low last week, but mortgage applications -- for both purchases and refinances -- were virtually flat. In this case, the government buyer credit already ate up most of the existing demand for home purchases. Other consumers remain wary about home buying, still shaken by the bubble's pop. There's also a large portion of the population who won't be able to get a mortgage for some years due to the harm to their credit that the recession caused through foreclosures or other loan delinquency. Of course, there's also no reason why lower long-term interest rates would influence people to dust off their credit cards. At best, low longer-term interest rates might increase some auto sales, though probably modestly since underemployment remains around 15% and consumers are still very cautious about making big purchases.

So the Fed's latest action probably won't do much to spur consumer consumption. Given how big a part the U.S. consumer plays in the economy, the action's effect will likely be limited. In fact, there's some chance the new policy change could worsen the situation: it makes clear that the Fed is deeply concerned about the economy, which could confirm Americans' fears and make them even more conservative about spending.