[quote=dumbrenter]
SK, that was a pretty good tutorial on how Fed works. Thanks for taking time to write it.
The way I understand this is: By buying US government securities, the Fed actions ended up lowering the yields on them (as a stated policy). This low yield forced banks (and others) to look for higher yield elsewhere, i.e. mortgages etc.
Assuming the above to be correct, you are right that the Fed was not a party to mispricing the risk, but their actions definitely contributed to it.
It is not like they did not see this happening; question is what motivated them to keep the yields so low with their actions?[/quote]
Quantitative easing, (QE, QE 2, and QE 3) didn’t start until after the credit crisis. They didn’t use the buying of government debt to manipulate interest rates to any great extent before that. One of their charges is to maintain a stable market. I believe they did buy/sell treasuries to that end prior to the crisis, but they currently hold about 2 1/2 times in US Government debt than they held before the crisis. The Fed has also purchased over $1.2 trillion in mortgage backed securities, up from zero before the crisis.
The Fed is owned by banks. Banks own debt. That’s how they make money, by lending money.What banks fear more than anything other than bad debt is inflation. Inflation kills the value of debt. Higher interest rates curb inflation. So their motivation has always been to keep the discount rate (which is the only rate they set) as low as possible without encouraging high inflation.
