So what happens if the economic bailout works?
The Federal Reserve decided to leave the target interest rate between 0% and 0.25% today. Even before the Fed’s news, the market had soared, and it’s continued its climb upward since the Fed’s announcement. As of this writing, it’s up more than 2.5%.
I’ve always tried to be as candid in this blog as possible. While I did write that the stock market appears to be undervalued a couple months ago, I don’t understand why the stock market run up has been so dramatic. As the Fed’s statement today noted, the economic picture is still worsening, albeit at a slower pace.
Fed chairman Ben Bernanke
What really has me worried though is what happens once the economy does turn around. The stock market tumble has been marked by a flight to quality: risky assets, such as stocks, have been shunned in favor of ultrasafe assets. The ultrasafe asset of choice for the world’s investors has always been the U.S. Treasury bond.
So, billions of dollars that got pulled out of the stock market went into Treasuries, driving their prices down, and allowing the federal government to finance this bailout at extremely low rates. As long as people desperately want Treasury bonds, the government can continue to borrow money at only 1% to 3% interest.
But what happens when confidence in the market is restored, and that money comes streaming out of Treasury bonds and back into stocks? Sure, the picture looks good for the stock market, but what interest rate will the government have to offer to get people to keep buying Treasuries?
Take this quote from the Federal Reserve statement: “In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn.”
In other words, to keep interest rates low, the Federal Reserve is already buying Treasuries. This means that the federal government is already printing money.
Once people are willing to take risk again and less liable to buy Treasuries, how is the Federal Reserve going to be able to keep interest rates from getting out of control as tons of Treasury debt needs to be refinanced? A common answer is that the U.S. economy could grow its way out from under all that debt, but if nothing else, hasn’t the market proven itself to change its perception rapidly between euphoria and fear and back again? If so, do we have time for the market to grow the country out of debt?
It’s a classic catch-22. The government’s success in restoring confidence in the markets will also make it more expensive for them to borrow money. I don’t have the answers to any of those questions. It’s just one more fear of mine that will or won’t play out down the road.
- Joe Light
