Truth and Consequences of the Fed Purchasing Treasuries

Mar.19.09 | About: iShares TIPS (TIP)

The Federal Reserve embedded in their FOMC news release the most dangerous weapon yet against deflation – they intend to purchase $300 billion of 2 to 10 year treasuries over the next 6 months. America is now purchasing its own debt.

The market rose on the news.

This was a complete surprise as there was no evidence of deflation taking hold. Both the Consumer Price Index (CPI) and the Producer Price Index (PPI) were stable, and some would have argued that inflation was now starting to win the battle. I was under the impression that the primary use of this monetary weapon was to fight deflation.

The second reason to debase is to consume the debt. The treasury auctions to date have been orderly and active. There have been no problems.

A third reason to debase your currency is to increase the competitiveness of your exports (and increase the price of imports) hoping to close the balance of trade deficit. There is little chance of doing that as oil (which is a big component of the deficit) should trend up matching the dollars fall, and China imports to the USA are usually priced in dollars anyway. You would debase at the end of a recession, not during it.

Then why debase now?

There is a phrase highlighted below in the statement by the Fed clarifying their purchases which bothers me:

The Federal Open Market Committee (FOMC) has announced that the Open Market Trading Desk (the Desk) will begin a Treasury purchase program of up to $300 billion to help improve conditions in private credit markets. The Desk will concentrate purchases in the 2- to 10-year sector of the nominal Treasury curve, although purchases will occur across the nominal Treasury and TIPS yield curves. Consistent with prior outright Treasury purchases, these purchases will be conducted with the Federal Reserve’s primary dealers through a series of competitive auctions via the Desk’s FedTrade system. On average, the Desk will purchase Treasury securities two to three times per week. Further details will be provided early next week after consultation with the primary dealers and other market participants. The Desk plans to hold the first purchase operation late next week.

Why TIPS (Treasury Inflation-Protected Securities)? Our inflation rates are controlled by the Fed’s actions. Is this the signal that they are not sure they can control inflation?

The only conclusion I can draw is that the government must believe they will not be able to finance the growing American debt in the future. The strength of the dollar was attracting offshore purchases of the dollar, and the safest place to put this money was in Treasuries.

But just the news of these purchases sent the dollar into a dive against most major currencies.

There is not a soul anymore that can say this recession is like any in the past. Debasing a currency is a very serious event – and has consequences which will damage certain sectors of our economy. Something very bad was being anticipated by the Fed, and was not revealed during this past weekend’s talk shows.

Maybe we should have Jon Stewart interview Fed Chairman Ben Bernanke.

Disclosures: None