Since the Troubled Assets Relief Program was passed by the Senate and House of Representatives in October 2008, there has been a lot of controversy surrounding the decision to have the U.S. government alleviate the current economic condition. The program is relatively simple; the U.S. Treasury would ultimately purchase $700 billion of troubled assets from mortgage intermediaries, such as Fannie Mae or Freddie Mac, as well as financial institutions, such as AIG or Bank of America. The goal of purchasing these toxic assets was to return liquidity to the assets that these financial giants held so that these companies would begin lending out to deficit units and therefore revitalize the overall economy.
Although this was initially seen by many as the best practice to prevent economic collapse, over the last six months there have been many indicators pointing to an overall economic standstill as far as lending and borrowing are concerned. The article, Treasury Prices Mixed on Seesaw Stock Market reveals that many investors are generally concerned about inflation rates rising thus affecting nominal interest rates on deficit units looking to borrow, as well as the prices of various Treasury securities, i.e. bonds, notes, and bills, decreasing due to an increase in the supply of loanable funds. Combine these factors with a decrease in demand from investors, who are hesitant to purchase Treasuries because they fear they will not be able to sell their securities in the secondary market for a profit, and the financial market is left with billions of dollars to lend out that surplus and deficit units simply don’t want.
Many potential investors are concerned about the inflation rate going up in the near future due to the Federal Reserve printing billions of dollars in order to purchase Treasury securities and troubled assets. Typically, when the supply of loanable funds increases, which is the case when the Fed prints billions of dollars, the demand for those loanable funds increases and an equilibrium interest rate is reached. However, due to mass media hysteria and a genuine concern that inflation will increase, many investors are shying away from investing in Treasury securities causing the demand of those securities to decrease; in effect lowering the price of said securities in the secondary market. As the articles sites, “Bondholders pay close attention to inflation gauges [CPI] because rising prices erode the value of fixed income assets such as Treasurys”. Many investors, who purchase Treasury bonds and notes, do so with the intention of selling them in the secondary market for a marginal gain. According to the Fisher Effect, if inflation rises as many investors suspect then those investors that purchased fixed rate securities risk making a minimal profit, if any at all. Therefore, investors are not purchasing Treasuries for two reasons; they believe that inflation will effectively rise causing them to lose money on a fixed rate security and investors are concerned that there will not be a secondary market to purchase their securities because new investors will have a higher required rate of return due to the spike in inflation, rendering their securities either unmarketable or unprofitable.
As the U.S. Treasury auctions off or sells more securities, the Fed and foreign countries, more specifically China, are purchasing them. The Fed is simply creating new money in order to buy up these securities, which will most likely lead to inflation. Although the Fed has pledged to purchase $300 billion in Treasury securities, financial institutions, such as banks and mortgage companies, are still not expressing a raised level of interest in purchasing these securities. Typically Treasury securities are 100 % no risk involved, however as concerns of increased inflation continue to grow and the national deficit increases, the U.S. is not as credit worthy and safe as investors would like. Investors feel the yields are still too small over a ten year (plus) period, where inflation would reduce their chances of making a profit on their coupon payments as well as by selling these securities. Of course, investors are also concerned about the U.S. government defaulting on paying these securities back. In effect, this lack of interest is lowering the demand for Treasuries, which lowers the price of these Treasury securities and also causes an increase in the supply of loanable funds; leading to a higher interest rate. This explains why interest rates are increasing while the prices of Treasury securities are decreasing.
This past week, Treasuries showed instability as the 10-year bond and the 3-month bill increased in price, while their yields decreased. Other Treasuries, such as the 30-year bond and the 2-year note decreased in price, while their respective yields increased. As investors grow wary about purchasing Treasury securities, they are looking at the recent stock market surge. This is occurring due to the fact that if investors are going to be risky with their investment, then they might as well play the stock market and at the very least put themselves in a position to reap greater profits with higher yields. Due to the growing anxiety over purchasing Treasury fixed rate securities coupled with inflationary worries, the Fed “is set to buy an undisclosed amount of Treasury Inflation Protected Securities, or TIPS”. TIPS are like any other security in that it pays the owner of the security a fixed semi-annual interest payment (coupon payment), however it is different in that when the price of the security is adjusted accordingly with inflation, so as to guarantee the owner profits or breaks even. As the price is adjusted, so are the coupon payments (the coupon payments are calculated by multiplying the fixed interest rate by the adjusted principal value of the bond and then divided by two*). In essence, TIPS are the safest security to purchase for any investor, especially an investor that is concerned about inflation.
The Federal Reserve needs to do something to ease worries of inflation. While purchasing billions of dollars in troubled assets and Treasury securities is noble, the Fed is giving investors a genuine concern over inflation since so much “new” money is being printed to buy up securities. The Fed needs to stop printing billions of dollars out of thin air to purchase Treasury securities, which in essence is only creating an artificial and temporary demand for such securities. Even China, who has invested $744.2 billion in Treasury securities, has put a stop to their spending out of fear that they will lose money in the long run. As the Fed prints more new money to purchase securities the inflation rate will rise, which would only lead to higher nominal rates, less borrowing, and less lending. The Fed is pushing too hard to correct the economy by manipulating the financial market and if they are not careful, the result could be very similar to the inflation crisis this country faced in the 1980’s.
*Divide by 2 because the owner of the bond receives semi-annual payments.
Image Used in this Post
The Federal Reserve image courtesy of Flickr user tiseb published under the CC license.
7 Comments
I’m not sure who is confused here, you or me, but…
How can a lack of demand for Treasury securities cause an increase in loanable funds? I was under the impression that the issuance of these securities was meant to fund the purchase of TARP, and TARP is what was meant to increase the loanable funds by freeing up banks’ cash for lending. So, by that logic, if the Treasury securities aren’t being purchased, then the government doesn’t have money to fund TARP and the banks are not freeing cash up to lend. That would not indicate an increase in loanable funds. Am I missing something?
Well… I could definitely be confused, but…
If investors are not buying up securities, then there should be an increase in the supply of loanable funds. The logic used here is that because less people want to buy these securities then there are less loanable funds being utilized, which would cause the supply to increase proportionally. The government does have money to fund TARP because they are printing trillions of dollars that banks and other financial institutions are not using. Therefore as the supply continues to increase (printing up money for the FED to purchase securities) it is clear that other investors, such as banks, etc, are not demanding to use that supply to buy up Treasuries.
I forgot to say that as the demand goes down, the supply increases.
But Treasury securities are basically a loan to the government. So why would a bank that is requesting money from the government want to purchase Treasury securities, thereby lending the government money? It goes against the entire point of the bail-out.
And, if the banks are using their cash to purchase Treasury securities that no longer have a readily available secondary market, then they do not have adequate liquidity to make loans. If banks can’t lend, how can the loanable funds increase? What I am talking about has nothing to do with the printing of money, although I acknowledge that it factors into the broader topic.
Right, I think we are talking about two different loanable funds graphs. I am talking about the government loanable funds.
Regardless the biggest bank in the land is purchasing these treasuries, in billions of dollars. The Fed, an independent bank, is using their newly printed money to buy various securities that the U.S. Treasury is issuing. So did China in the amount of $744 billion. So these securities are definitely getting purchased (just at too slow of a rate – leading to a surplus of loanable funds). I guess what I’m trying to say is that investors that are looking for safe, decent yielding investments are hesitant to buy these same securities for the same reason the China stopped buying these securities. They are afraid that there is not going to be an active secondary market to sell off their bonds, etc. The prices of securities will drop on the primary market and why would an investors want to buy a security on the secondary market if they can buy one on the primary market for a lower price and higher yield?
As far as the loanable funds for banks goes, they don’t want to buy up these securities either for the same reasons. Now sure some of them need to, but a lot of banks are trying to make due without them. The problem now is that the government is pretty much making them….which is an entire different discussion.
Perhaps…
But to be honest, I’m not sure you really understand the topic you are discussing. It’s either that or you are not properly articulating your meaning. I could go through your last reply point by point highlighting the inconsistencies and misrepresentations, but its just too painful for everyone involved. I guess I will remain unsatisfied in this matter.
My response – which may not be correct, but certainly seems logically to me…
You are talking apples and oranges. These are different subjects, which will all cause a circ at some point because everything is dependent on everything else…
The cash is available for TARP because the US is printing money – end of story. The banks don’t want the tarp money because the restrictions are too difficult to maintain. Printing money = inflation – Where is the money going if not to the banks – I have no idea…
I would think that loanable funds per the article is loanable funds from the government, not from the banks. The banks have been holding any cash they can get their hands on so they don’t go bankrupt or get purchased. They are just starting to loan again but with high restrictions and the interest rates are adjusted for the risk.
The low interest rates of the Treasuries, et al, are causing the lack of interest in the purchase of the bonds by investors. Would you prefer to have $100 bucks in your pocket today or a note for $101? Seems like the burger today for a buck tomorrow – Sorry – going off on tangents again…:)