Fed presses on into uncharted territory

Those helicopter drops aren’t being announced with the same fanfare as the Fed’s changes interest rate policy. But they’ve been showing up in the weekly statistics the central bank provides on its balance sheet, the accounting of overall assets and liabilities.

Since the beginning of September, the Fed’s books have swollen as it has been buying debt assets from banks and corporations — paying cash in an effort to pump more money into the system. In the past three months, the Fed’s balance sheet has jumped to $2.3 trillion after holding steady for almost a year at about $900 billion.

The central bank is also shifting its emphasis on the kinds of debts it is buying. Under normal circumstances, the Fed’s so-called “open market operations” involve buying and selling U.S. Treasuries to fine tune the rate charged on short-term loans.

But the global financial meltdown has already sent private buyers stampeding to buy Treasuries, pushing rates to zero as investors seek the safety of securities backed by the U.S. government. (For brief periods, the rate on short-term Treasuries has fallen below zero, as investors accept a slight loss in return for the assurance they’ll get their money back.)

As a result, the Fed has turned to buying other kinds of debt securities, including the so-called “commercial paper” that companies and banks sell to fund their borrowing. Last month, the Fed announced it would buy $600 billion in debt and mortgage-backed securities from mortgage giants Fannie Mae and Freddie Mac. With investors shying away from mortgage-backed debt, the Fed is hoping to supply more cash to that market to try to push mortgage rates lower.

“it's beginning to matter more what the Fed buys to expand money and liquidity than how much is expanded,” said McTeer. “They've started buying other than Treasury bills to unfreeze some of these markets.”

With the economy shrinking and unemployment rising rapidly, the Fed’s move to flood the system with money will take time to have an effect. Economists expect the economy to continue to shrink at least through the middle of next year, if all goes well.

Those forecasts also anticipate another major spending program by the government to stimulate the economy.  President-elect Obama’s transition team is already working with Congress on a spending package that could approach $1 trillion, according to published reports.

“It is critical that the other branches of government step up,” Obama told reporters at a news conference Tuesday.

Under normal circumstances, this flood of government spending and asset purchases by the Fed would pose a major risk of inflation. Economists say that long-term threat is very real. But for the moment, the ongoing drop in prices of assets like housing and stocks to commodities like gasoline has pushed that inflation risk into the future.

Falling prices have also helped ease the credit burden on consumers. The sharp drop in energy prices — gasoline prices have dropped 87 percent in the past three months — has boosted consumers’ spending power buy about $130 billion, according to RDQ chief economist John Ryding.

“We’ve had a huge tax cut,” said Stuart Hoffman, Chief Economist at PNC Financial. “The catch is you've got to have a job.”

Though falling prices boost consumers' spending power, a continued slide, known as deflation, can be even more damaging to the economy. Once deflation takes hold, consumers delay purchases, companies adjust to lower demand by slowing production and cutting jobs, which causes consumers to scale back spending even more. The downward spiral feeds on itself.

The Fed is hoping to prevent that from happening by “inflating” the economy with its multi-trillion-dollar buyback of debt. But as the economy recovers, the Fed’s new strategy of “quantitative easing” will pose a new set of challenges.

At some point, once the economy begins to recover, the Fed will face yet another monumental challenge: how to drain trillions of dollars of excess cash from the economy to avoid a new bout of inflation or another credit bubble. If it starts draining money too soon, it risks throwing the economy into another slide. That means the Fed’s outsized role in managing the economy with its new strategy will likely remain in place for some time to come, according to Credit Suisse chief economist Neil Soss.

“There is no exit strategy from this entanglement, anywhere,” he wrote in a note to clients this week.

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