- On March 19 the New York Times reported: "The Fed
said it would purchase an additional $750 billion worth of government-guaranteed
mortgage-backed securities, on top of the $500 billion that it is currently
in the process of buying. In addition, the Fed said it would buy up to
$300 billion worth of longer-term Treasury securities over the next six
months."
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- The Federal Reserve says that its purchase of $1 trillion
in existing bonds is part of its plan to revive the economy. Another way
to view the Fed's announcement is to see it as a preemptive rescue. Is
the Fed rescuing banks from their bond portfolios prior to the destruction
of bond prices by inflation?
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- The answer to this question probably lies in the answer
to the unanswered question of how the unprecedented sizes of the FY 2009
and FY 2010 federal budget deficits will be financed. Neither the US savings
rate nor the trade surpluses of our major foreign lenders are sufficient.
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- I know of only two ways of financing the looming monster
deficits. One, courtesy of Pam Martens, is that the federal deficits could
be financed by further flight from equities and other investments.
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- This is a possibility. If the mortgage-back security
problem is real and not contrived, the next shock should arise from commercial
real estate. Stores are closing in shopping centers, and vacancies are
rising in office buildings. Without rents, the mortgages can't be paid.
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- Another scare and another big drop in the stock market
will set off a second "flight to quality" and finance the budget
deficits.
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- The other way is to print money. John Williams (shadowstats.com)
thinks that the budget deficits will be financed by monetizing debt. The
Federal Reserve will buy most of the new bonds and create demand deposits
for the Treasury. In effect, the money supply will grow by the amount of
Fed purchases of new Treasury debt. Printing money to finance the government's
budget normally leads to high inflation and high interest rates.
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- The initial impact of the announcement of the Fed's plan
to purchase existing debt was to drive up the bond prices. However, if
the reserves poured into the banking system by the bond purchases result
in new money growth, and if the Fed purchases the new debt issues to finance
the governments' budget deficits, the outlook for bond prices and the dollar
becomes poor.
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- It will be interesting to see how the currency markets
view the problem. The New York Times reported that "the dollar plunged
about 3 percent against other major currencies" in response to the
Fed's announcement.
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- If the exchange value of the dollar works its way down,
it will complicate the financing of the trade deficit and impact the decisions
of foreigners who hold large stocks of US dollar debt. The premier of China
recently expressed his concern about the safety of his country's large
investment in US dollar debt.
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- If the US government is forced to print money to cover
the high costs of its wars and bailouts, things could fall apart very quickly.
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