Fed Faces Its Zimbabwe Moment

Is the central bank confident enough about the recovery to take the economy off life support?

WASHINGTON -- (Forbes) When stock markets plumbed new lows in March, the Federal Reserve responded with nearly every tool in its box. It announced it would create new money to buy $1.25 trillion in mortgages and $300 billion in government debt.

That purchase of government debt looked particularly ominous. Creating new money to buy government debt is the sort of strategy that's known to destroy economies--just ask Zimbabwe, which suffered so much hyperinflation that it destroyed its currency. The Zimbabwe central bank printed bills in the denomination of 100 trillion Zimbabwean dollars, then found they had value only as a novelty item on eBay. Eventually, Zimbabwe was forced to abandon its currency altogether.

But the difference between the U.S. Federal Reserve and the Reserve Bank of Zimbabwe (one would hope) is that the Federal Reserve will stop before it wrecks the dollar.

The first major test of the differences between Zimbabwe and the U.S. is rapidly approaching. An indication could come as soon as the Fed releases a policy statement Wednesday afternoon. The Fed is not expected to announce a major change of course (see "All Quiet On The FOMC Front"), but the present course calls for current programs to unwind.

The first program to end is the purchasing of government debt. In its March 18 meeting, the Federal Reserve announced that "to help improve conditions in private credit markets" it would purchase $300 billion of government debt. The Fed wanted markets to believe it was purchasing these Treasuries for the purpose of lowering interest rates. Since much borrowing is ultimately benchmarked against the yield on Treasuries, if the Fed purchases Treasury debt, it should make borrowing easier throughout the economy.

The Fed stated it would make these purchases for six months. As of Aug. 5, according to the Federal Reserve Bank of Atlanta, it has purchased $236 billion of government debt. By the time the Federal Reserve meets again in September, it is likely to have spent all $300 billion, and the six months will be over.

It is a tricky moment for the Fed. If it continues buying government debt, it may help keep interest rates low, but it would raise concerns that the country is inching ever closer to Zimbabwe (and, of course, if enough people believe we're headed down the Zimbabwean road, it would eventually become a self-fulfilling prophecy).

By Joshua Zumbrun, 08.11.09, 05:45 PM EDT
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