What the Fed's $600 Billion Plan Really Means
Posted Nov 03, 2010 04:19pm EDT by Daniel Gross in Investing, Banking, Politics
Related: tlt, tbt, ^tnx, tip, ^dji, ^gspc, spy
EmailPrint.The Federal Reserve Wednesday announced its latest effort to spur economic growth: a plan to purchase up to $600 billion of government bonds through June 2011.
Why is the Federal Reserve buying bonds?
It wants to lower interest rates, in the hopes that doing so will loosen the supply of credit and spur more economic activity. The central bank’s main tool for reducing rates is to slash the short-term overnight lending that banks charge to one another, the so-called Federal Funds rate. Bring short-term rates down, and long-term rates tend to follow. In normal times, that’s as far as the Fed usually goes. In the past three years, the Fed has reduced the Fed Funds target rate 10 times, from 5.25 percent to between zero and .25 percent. It’s been at that extremely low level since the fall of 2008.
Once the Fed Funds rate can’t get any lower, what else can the Fed do?
It can buy assets, or engage in what’s known as quantitative easing (QE). Adjusting the Fed Funds directly influences short-term rates. The Fed can also influence long-term rates by purchasing (or selling) long-term debt in the open market. When lots of people -- or one big buyer -- buy bonds at the same time, it drives prices up and interest rates down. As the nation’s central bank, the Fed can create money and simply announce that it will buy large quantities of bonds.
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