FED's Bond Buying Program

In my previous post, I explained what bonds are and why the bond market is the most important market in a country. This post will explain the recent bond-buying program taken by the FED and why the inevitable end of it frightens investors and emerging economies.

What is the FED? 

“The Federal Reserve is the gatekeeper of the U.S. economy. It is the central bank of the United States -- it is the bank of banks and the bank of the U.S. government. The Fed regulates financial institutions, manages the nation's money and influences the economy. By raising and lowering interest rates, creating money and using a few other tricks, the Fed can either stimulate or slow down the economy. This manipulation helps maintain low inflation, high employment rates, and manufacturing output.”


What is the bond-buying program taken by the FED?

Government bonds are traded in the bond market. As explained in my previous post, the price and interest rate of bonds are influenced by the well being of the economy and the investors’ perception of it. If the economy of the US is not doing well, investors, fearing recession or inflation, will avoid buying government bonds. In this scenario, supply would exceed demand, and therefore bonds would lose value, only aggravating the mistrust with the American economy.

To avoid the depression in 2009, (as part of many other economic measures) the FED decided to lower interest rates to nearly zero. Lowering interest rates makes borrowing money cheaper; therefore, people are more likely to spend it, stimulating the economy. In September 2012, the FED decided to stimulate the economy even further. Since interest rates were already at nearly zero, they decided to buy government bonds. By buying government bonds from the bond market, these securities are now on the FED’s books and new money is available to the banking system. Both measures provided liquidity to the economy. The FED expects that with this new money available, investors will venture into the stock market or corporate bond market, henceforth stimulating the economy once again. This policy of providing liquidity to the economy is called Quantitative Easing (QE), and it has been very successful thus far.

Before the 2008 financial crisis, the FED had $800 billion in government bonds. Today, the number is close to $4 trillion. Since the FED has already accumulated so many bonds, QE becomes less effective each day. The US and the global economy have shown several signs of recovery, and it might be time to end this stimulus; the FED can’t keep printing money forever. However, the FED also can’t simply stop buying bonds out of no-where. That would cause turmoil in the markets. In recent months, the FED engaged in something called tapering, which is the gradual reduction in purchases of bonds. In 2013, the monthly bond purchases were $85 billion, and now they are at $65 billion."

*Note: If you are wondering why the FED can simply buy bonds, it’s because the FED can simply create new money. Remember: The FED is the central bank of US, the bank of banks and the bank of the government.

How does this affect financial markets and emerging economies?

The FED needs to be very careful when tapering, since it has already caused negative reactions in several emerging economies, including Turkey, South Africa, and Argentina. Investors expect that with the end of QE, interest rates will rise in the US. There has been a big sell out in currencies, bonds, and stocks from emerging markets, flowing back in to the US. Many emerging economies rely heavily in FDI (Foreign Direct Investment). The fact that these US dollars are heading back home, in addition to Euros, scares them.

The G-20 met this weekend in Sydney to discuss the impact of tapering in emerging economies and to see if they can cooperate in order to avoid a financial folly. Emerging economies want the US to slow down tapering, while the US most likely will not. Reuters just posted: "There was proper recognition that the movement of monetary policy in major developed countries is going to have an impact on emerging economies and there was proper recognition that will be taken into account in the foreseeable future." Stay tuned.

Thanks for reading,

Pedro

Sources
"HIGHLIGHTS-Comments from policymakers after G20 meeting in Sydney." Reuters 23 02 2014, n. pag. Web. 23 Feb. 2014. <http://www.reuters.com/article/2014/02/23/g20-australia-idUSSYDG2020140223>.
Rushton, Katherine. "Federal Reserve could raise interest rates 'soon'." Telegraph 19 02 2014, n. pag. Web. 23 Feb. 2014. <http://www.telegraph.co.uk/finance/economics/10650102/Federal-Reserve-could-raise-interest-rates-soon.html>.
Schaefer, Steve. "Why Panic-Prone Emerging Markets Are Breaking Down In 2014." Forbes 03 02 2014, n. pag. Web. 23 Feb. 2014. <http://www.forbes.com/sites/steveschaefer/2014/02/03/why-panic-prone-emerging-markets-are-breaking-down-in-2014/>.
"How the FED works." How Stuff Works n.d., n. pag. Print. <http://money.howstuffworks.com/fed.htm>.
Irwin, Neil. "The Fed might taper bond buying this week. Here’s everything you need to know.." Washington Post 16 12 2013, n. pag. Web. 23 Feb. 2014 <http://www.washingtonpost.com/blogs/wonkblog/wp/2013/12/16/the-fed-might-taper-bond-buying-this-week-heres-everything-you-need-to-know/>.