Question

What are the Economic Risks of Aggressive FED Open Market Purchases?

Answer 1

As an overview, when the fed pursues open market purchase of bonds, is it an expansionary monetary policy. When the fed purchases bonds from banks and financial institutions, the bonds are exchanged for cash. This infuses liquidity in the banking system and the federal fund rate is pushed lower. When the federal fund rate declines, the cost of funding for the banks also declines and banks pass the benefit to consumers by lowering interest rates.

While lowering of interest rates can help boost economic growth by stimulating leveraged investment and consumption spending, there are several risks related to aggressive open market purchase of bonds by the fed. Some of the key risks are as follows -

1. In the fractional reserve banking system, it is credit growth that creates money in the economic system. When credit growth is robust at low interest rates, there is excessive money creation and it results in inflationary pressure on the economy. Importantly, as leveraged consumption and investment spending accelerates, the economy moves into a inflationary gap. Therefore, risk of run away inflation is high when the fed pursues aggressive open market purchase.
2. When the economy is already operating at potential GDP or moves above potential GDP, there is less appetite in the economy for investment spending or consumption spending. However, as interest rates are low, money is borrowed and diverted to speculation across asset classes. It is ultra expansionary monetary policy that resulted in the housing bubble and the stock market bubble. Therefore, another big risk relates to asset bubbles that can trigger a financial crisis.