THE US central bank, the Federal Reserve, took world financial markets by surprise with its decision to buy $300 billion of American government debt over the next six months. A move that was anticipated later this year has come much sooner and has raised some concern that this dramatic initiative is in response to further deterioration in the US economic outlook.
The bank’s intention is to purchase longer-term treasury securities – government bonds – in an attempt to pull the US economy out of recession and to prevent deflation taking hold. Like the Bank of England, Britain’s central bank, the Federal Reserve had run out of policy options. With interest rates at close to zero in both countries, further rate reductions were not possible. Lower borrowing costs had failed to increase bank lending or consumer spending and desperate economic circumstances therefore required desperate measures.
The central banks in Britain and the US have now adopted a broadly similar approach, printing money in order to raise the supply of credit. And if that proves successful, then longer-term interest rates (for corporate loans and house mortgages) should fall and credit conditions should ease.
However, this radical monetary experiment is not risk-free. The policy of quantitative easing, where central banks buy government debt, is only adopted when more orthodox forms of monetary expansion have clearly failed. Central banks then step in to act as spenders of last resort. They buy government debt in an effort to kick-start credit markets and the economy. And they do so in the expectation that bond yields will fall, thereby lowering longer-term interest rates. Companies can then issue debt at cheaper levels and use the money raised to invest in business projects that increase employment. That should help boost spending and raise confidence. And banks, in consequence, should become more willing to lend and consumers to borrow. The impressive results in Britain so far may well have encouraged the US to follow suit on Wednesday.
Nevertheless, the hazards involved in this very unconventional approach should not be under-estimated. Central banks, having stepped in to avert one crisis, must later manage to step out without precipitating another; whether higher inflation or huge capital losses in selling the financial assets they have purchased.
For the European Central Bank (ECB), interest rates at 1.5 per cent are at a record low but remain above those in the US and the UK. Therefore, some scope for further cuts exists. That places the ECB under less pressure to follow the British and American lead. However, ECB president Jean-Claude Trichet has been careful not to rule out any options. On Wednesday, he said the bank was “studying further measures and assessing the possible need for them”. One obvious problem arises for the ECB. As the euro zone doesn’t issue its own bonds, it would have to buy the bonds issued by member states. And that would involve a difficult political decision: whose debt to buy and how much?