Fed Market Manipulations

 It is unclear to me what the long term effect will be of the Fed’s huge role in the financial markets, not just for the pandemic, but since the 2008 great recession.  Interest rates have been close to zero despite stock and real estate markets that have been on fire.  Part of the reason may have been the Fed’s program of buying all kinds of bonds. 

When people want to buy bonds, interest rates stay low.  Governments or companies do not have to offer higher rates to entice investors to buy the bonds.  If it is hard to sell bonds, then borrowers have to offer higher interest rates to persuade buyers to buy.  If the bond market is unattractive to ordinary bond buyers, but the Fed steps in to buy at any price, the Fed keeps rates lower than they would be in a free market. 

What happens if these bonds go bad?  The Fed currently holds about $7 trillion in assets.  Presumably most of these are US government bonds.  While the Fed’s ability to purchase assets is unlimited, its ability to sell assets is limited by the amount of assets it holds.  If those assets become worthless, the Fed’s ability to sell them becomes more and more limited.  The Fed sells assets to fight inflation and keep interest rates low.  Currently there is no need to do this, since interest rates are zero. 

At some point, however, the dollar could threaten to become worthless.  Currently the dollar is the main international currency, which means that the US and other countries borrow in dollars.  China holds an enormous amount of US dollars.  According to MarketWatch, China holds $1.2 trillion of US debt; Japan holds $1 trillion, Brazil and Ireland hold $300 billion each, while other countries hold lesser amounts.  If the dollar became worthless, i.e., its value dropped precipitously against the yuan and the yen, the US would have to start paying much more for imports and perhaps pay in other currencies, such as the Euro.  More expensive imports would be inflationary, creating pressure on the Fed to sell assets that are becoming worthless. 

Although this scenario seems unlikely at the moment, with inflation at zero and the economy doing well, it is not out of the question for future.  The Fed should be thinking about how to unwind its huge asset holdings. The last time the US faced a debt problem like this, during World War II, it issued savings bonds and encouraged patriotic Americans to buy them, basically to finance the war effort.  It is not clear that most Americans are patriotic enough to do that again, especially if there is no threat of a physical, military invasion. 

In particular, black Americans do not like America.  They expect the government to give them money.  They are not interested in giving money to the government so that the country can survive.  Blacks probably won’t buy savings bonds, like white Americans did during World War II.  So, the government and the Fed would have to find some other mechanism to help the United States survive a different kind of economic calamity.  For now, we’ll just hope it doesn’t come, and that the government can just keep throwing money into the air for whoever can catch it first, probably Wall Street tycoons.