US central bank has reassured investors it will help avert a double dip recession: Maley

US markets heaved a brief sigh of relief overnight after the US Federal Reserve announced that it would reinvest the proceeds from maturing mortgage-backed securities into longer-term US government bonds.

The move – which was widely expected – is seen as a “baby step” towards a massive new $US2 trillion quantitative easing program which many believe the US central bank will embark on either later this year, or early next year in order to bolster the economy. There were fears that conditions in US money markets could have tightened up and pushed interest rates higher had the US central bank disappointed markets by delaying its move.

US Treasury markets responded positively to the US Fed’s decision, with the yield on 10-year bonds falling to 2.77%, its lowest level since April 2009. Investors are now confident that the US Fed, which only a few months ago was contemplating a possible tightening of monetary policy, is once again prepared to resort to unconventional monetary policy tools in order to avert a “double dip” recession.

The US Fed has clearly become more pessimistic on the US economic outlook, conceding that the “pace of recovery in output and employment has slowed in recent months”. Consumer spending continued to be weighed down by high unemployment, tepid income growth, lower housing wealth and tight credit. And although businesses were spending more on equipment and software, they remained reluctant to hire new workers. The central bank saw little threat from inflation for some time, and renewed its pledge to keep short-term interest rates close to zero for an “extended period”.

The US Fed’s decision came as the National Federation of Independent Business (NFIB) reported that its small business optimism index dropped in July. Small businesses reported poor sales, and were worried about the outlook for business conditions over the next six months.

The US Fed’s decision to reinvest the proceeds of expiring mortgage backed securities into longer-term treasury bonds does not actually represent an easing of monetary policy, because it keeps the size of the central bank’s balance sheet steady.

But it does signal that the central bank is prepared to once again embrace the unconventional monetary policy of buying huge quantities of financial assets should the economy deteriorate further.

As part of its response to the financial crisis, the US Fed purchased $US1.7 trillion in mortgage-backed securities and US government bonds in an effort to improve market liquidity and to drive down long-term interest rates. As a result, the US Fed’s balance sheet has now swollen to $US2.3 trillion.

But although some economists argue that the US Fed should do everything possible to drive down long-term interest rates to stop the US economy falling into a Japanese-style deflation, others query whether there is much more room for interest rates to fall. Already average rates on 30-year mortgages are at the lowest levels since the 1950s, while yields on triple-A rated corporate bonds are trading at the lowest levels in 40 years.

There are doubts whether further cuts in the debt servicing costs of consumers and businesses will fuel a significant economic rebound in an environment where consumers, concerned about their job prospects, are continuing to tighten their belts, and businesses fret about the outlook for sales.

This article first appeared on Business Spectator.