Fed Pursues Quantitiative Easing But Consumers May Not Respond

Over the last two weeks, the Fed has set up programs to purchase mortgage backed assets, student loans, credit card loans, and more to help restart lending. But it might not make a difference because consumers are already eyeball high in debt and need less of it, not more.

Over the last two weeks the Fed has pursued a policy known as quantitative easing.  In addition to lowering the Fed Funds rate to 1% (expectations are it will drop further), the Fed has also agreed to buy hundreds of billions in mortgage, credit card, student loan, and other consumer-related debt.  The goal of these programs is to take these assets off bank balance sheets and replace it with cash that can be lent out.  In essence, this replaces the securitization markets which have stopped functioning.

In theory this should work and the impact on mortgage interest rates yesterday was immediate.  Rates fell by half a percentage point (50 basis points), the biggest one day drop ever.  Banks can now clear out loans sitting on their balance sheet and restock the cash available for new lending.  But there are several reasons why this might not work:

1. Consumers are already saddled with record debt and may not be interested in taking on new obligations.  Consumers debt service ratio (the percentage of income that consumers pay to debt) has risen steadily over the last 28 years to a record level in 2008.  

2. Banks don't want to lend in a recessionary environment where even good credit score customers are defaulting.  No one can predict the severity of the recession.  Banks are already taking heavy losses on loans given in good times.  Their portfolios are going bad and many of their mortgage loans are souring further as housing prices continue to drop.  Unemployment is up.  It's not the best time to be extending credit.

In the 1990s, Japan tried quantitative easing to get its economy moving and the results were mixed.  Per Bloomberg:

"The Bank of Japan is the only major central bank to deploy quantitative easing in modern times, from 2001 to 2006. Current Governor Masaaki Shirakawa said in May that the policy "was very effective in stabilizing financial markets,'' while at the same time it had "limited impact'' in resolving Japan's economic stagnation of the time because banks wouldn't lend and companies wouldn't borrow."

In the US the central dilemma is this.  Consumers are fatigued and those that aren't fatigued, are scared.  We've heard about how low the US savings rate is and the government has long urged consumers to save more.  Everyone knows that the heart of this credit crisis is an addiction and overreliance on borrowing by US consumers.  We borrowed above our means to buy houses, to buy cars, to buy plasma televisions.  But the Fed's actions and quantitiative easing is like giving heroine to a recovering junkie.  Sure, it will make the withdrawal symptoms go away for a little while, but it won't cure the underlying problem.

Sam Cass
Sam Cass: Sam Cass, MBA, JD, University of Texas at Austin. Always a fan of Leonardo Da Vinci.

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Comments

  • Dave Lowry

    November 27, 2008

    Agree. Hard to borrow more when already borrowed up to eyeballs. Credit card companies raising rates (Citi) doesn't help either. Quantitative easing sounds like a technical term for create cheap money.

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