I wish there were an online translator for Fedspeak to English, but until that great day we'll do our best. Here's an explainer for what the Federal Reserve announced yesterday.
Q: What is the Fed doing?
Basically it's going to increase the amount of money out there by a trillion dollars.
Q: How the heck do you do that?
The Fed has the power to create money essentially out of thin air. It does this by buying things (typically treasury bonds) from the market. So the Fed takes the bond, pays for it with money. Voila, the money supply has grown.
Q: What's the point?
The Fed says it wants to improve the mortgage lending market, and that is how a good part of that trillion dollars will enter the economy. The Fed pledged to buy $750 billion of mortgage backed securities, guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. So the Fed is basically increasing the pool of money available to lend to people who want to buy houses. And when there is more money available, the interest rates for mortgages drop. The Fed has been doing this for a while, but yesterday's announcement more than doubles the effort. This year it could buy up to $1.25 trillion worth of these mortgage backed securities.
The Fed also said yesterday it would buy up to $300 billion of longer-term Treasury bonds.
Q: Why longer term?
Short-term bonds are paying almost no interest right now. So from a bank's perspective, swapping one for cash doesn't really make much difference. Money pays zero percent interest. But short term treasuries are about the same. So buying short term treasury bonds doesn't encourage the banks to lend money to, say some guy who wants to buy a car.
But long-term bonds pay more interest. (The yield on a 10-year treasury is 2.6% at this moment.) So the Fed can still push things around here.
Buying long term bonds tends to push the price of those bonds up, which means the effective interest rate they pay (the yield) will drop. That's what the Fed wants.
Here's why. This chart shows how if long term treasury yields drop, mortgage rates will too. Why? They're both long-term investments. Mortgages are a more risky investment, on this chart they tend to pay a 2% higher interest rate than ten year treasuries. But they move together. (If the mortgage rates didn't drop to follow treasuries, they'd look like a really good investment relative to treasury bonds, and people would buy them up, pushing the price up and the yield down until mortgage rats and treasury yields were in synch again. I know that's a little complicated, but that's how the entire market works. You adjust one key thing, and everything else shifts.)
James Hamilton at the University of California San Diego argues that the Fed is also acting to prevent the dreaded possibility of deflation. Hamilton says it sends a strong signal to investors worried we might fall into that hole: "The Fed slapped them on the face pretty hard, and said 'You got that wrong. We are not going to let that happen.'"
Q: What's the danger?
Inflation. Putting more money into the world tends to push prices up. To prevent that from happening, eventually the Fed is going to have to suck some of that money back out of the economy by raising interest rates or selling back those Treasury bonds into the market. And sucking money out of the economy is never fun. Hamilton points to the recession in the early 80's, driven largely, he says, by efforts to reign in inflation.