4) As conditions in short term financial markets improved by summer of 2009 the

Question

4) As conditions in short term financial markets improved by summer of 2009 the Fed closed down its lending under these programs mentioned in Q3 above. However, throughout the next 4 years the Fed increased substantially its purchases of longer term mortgage backed securities and Treasury notes from banks in a series of 3 “Quantitative Easing” (QE) Programs.

A) Assume that both lender & borrower confidence levels start to return to normal and financial and physical investment levels start to rise much more strongly in the next 12 months than in the last few years. What potential problems will the extraordinary growth in banks’ reserve deposits and in the size of the Fed’s portfolio of longer term Treasury and Mortgage backed bonds that has resulted from 3 rounds of Quantitative Easing create then for the Fed?

Explanation / Answer

As a result of various measures taken, the banks are being flooded with deposits. This at the face of it , seems to have two repurcussions- one is that it may be a signal that inspite of all the actions, the Fed has been unable to raise the demand for liquidity and the second is the increase in the deposit may fuel inflation.

How ever , it may be noted that the answer to these questions may not be as simple as it seems to be. Although the above mentioned repurcussions are a probability that may take place, there are some other aspects that need to be need to be cosidered.

As a consequence of increased deposits with the banks, the lenders may want to decrease the rate of interest thereby relasing more money into the system and hence into the hands of the general public. This in turn raises the buying power of the individual, which in turn shall increase the demand for goods and services.

This is the point wherein the actual issue shall arise. In case the produce of goods and services are short of the demand, this may give ruse to inflationary pressures. As such at this juncture, it is important to analyse the actins taken by the Government to ensure that the demand-supply side is adequately met up. A clear and well thought out strategy here shall be the actalyst for other aspects of the economy as well like employment levels etc.

From a Fed perspective, such a situation may first prompt the Fed to reduce the interest rate to enable liquidity amongst the individuals. How ever, the reduction in interest rate has to be in line with a cooridnated action by the Government on points mentioned above, as else, this may another problem for the Fed to handle.

To conclude, the problem for Fed shall be multiple in case cooridnated action is not taken by the Government to ensure adequate balance in the supply side alongside the actions by the Fed.

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