|
The Risks of Monetizing Debt - Part One |
by John Jagerson
The Federal Reserve has been using some unusual tactics to offset the effects of the credit crisis of 2007-2009. Individual investors should have a basic understanding of what these Fed activities are and what kinds of risks they present to their portfolios.
Learn more about what the Fed does through the articles and videos below:
- Understanding Quantitative Easing
- Is the Fed Really Running the Printing Presses?
- What is the Fed's Balance Sheet?
- What is the Fed and Why You Should Care
This article series will specifically address the concept of "debt monetization", which has become a very popular set of terms to use within the financial news media to describe the partnership between a government deficit spending plan and the Fed's open market activities. Debt monetization is not the same thing as "printing money" but it has many of the same effects.
Debt monetization describes the process of turning U.S. Treasury debt and private corporate debt into money. Simply stated, this happens when the Fed buys Treasury and corporate debt on the open market. When the Fed buys debt in the market its purchase increases the money supply.
During normal economic conditions the Fed will buy and sell debt to manage interest rates. When they buy debt and increase the money supply, interest rates should fall. Conversely, if the Fed sells debt, interest rates will rise. The Fed may want to raise interest rates to keep the economy from overheating and it may want to lower rates to stimulate a sluggish economy.
During the current credit crisis the Fed has had to buy an unprecedented amount of public and private debt to keep rates low. This process is sometimes referred to as quantitative easing and is ostensibly a temporary strategy that will be rolled back when the crisis eases. Eventually, the Fed would like to get the debt they hold back into the market, which theoretically would reduce the money supply by demonetizing the debt.
The Fed needs to buy this debt because the private money markets are unwilling or unable to do so in the quantities necessary at desired yield levels. Private companies have low value debt they need to get off their balance sheets and the U.S. government needs to have money to fund a budget that is in deficit. If the Fed did not buy the debt, yields would rise and it could significantly postpone economic recovery.
This presents a series of very unusual questions for investors. The Fed is essentially the largest market participant and they have clear stated objectives about where they want prices and yields to go. Should individual investors bet against the Fed? Is the Fed taking on too much risk? How do individual investors hedge this risk or take advantage of another potential bubble?
In the next article in this series I will discuss what the known risks of the Fed's strategy are and some ideas individual investors can use if things don't work out as planned. Ultimately, individual investors need to be flexible, educated and aware of what is going on around them. We can't forecast the future but we can prepare to take advantage of market changes when they do happen.
Next: How to Profit from Falling or Rising Home Prices
|
|
