Truth and Consequences of the Fed Purchasing Treasuries

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

Comments

[pslater:]

I have tought since last fall that what the Fed and Treasury are NOT telling us is that there is a coming wave of bank defaults that will dwarf anything we have seen so far. FDIC chair Sheila Bair is aware of this as she has asked Congress for a $500 billion line of credit. Considering that FDIC assets were a little over $50 billion last fall when this debacle started her request says a lot. I just hope she's not underestimating the problem by several orders of magnitude.....

Mar 19 02:01 PM

[PROXIMO:]

It seems to me all governments are forced to devalue their currency, eventually. Figure $10 million @ 5% for 300 years.

Mar 19 02:21 PM

[margel:]

Actually, the Fed has been planning this move for quite awhile. They have been concerned that the "output gap" between actual and potential GDP is supposed to be about $ 2.2 trillion and exceeds by a wide margin the recent government fiscal stimulus of only $785 billion even after accounting for multiplier effects. By dropping intermediate interest rates, this move may spur some increase in private investment. With an output gap of this size (about 1/6 of GDP), the greatest risk is deflation not inflation.

Mar 19 02:24 PM

[Just anothe...:]

Gentlepeople, with all due respect, you do not want to see nor even feel the specter of deflation. When it teeth take hold, it is already too late; much like an experience with a great white shark. Gentle Ben knows this just like Norman Gentle knows this even. So, where does that put us, it puts us in a environment post-crash, and the exit play is growth stocks. As most of you painfully know, the commodity boom was just that and nothing more then hot air from a guy named after a steak T-Boner. The commodity stocks are like Dell from 2000-until now. Every time the stocks/commodities peak up (pun intended), there are millions of Jimmy Rogers want-to-bees who can dream up all sorts of nasty scenarios for you. Additional siren songs include activist investors and the Graham and Dodd crowd who also just started their secular bear market. If you own something that is levered up, with no growth prospects and declining earnings due to selling products with little reason for earthly possession, then I think you should join David Karesh in the after-life. Yes, the US has undergone a terrible Grizzly Bear market, but if the banks do not dissolve overnight here and eventually we wind down the leverage of the ibanks, things will work themselves out fine. Remember it is easy to be a bear after the market is down 60%. - - Sincerely, Just another cracker

Mar 19 04:27 PM

[Sober Realist:]

"Something very bad was being anticipated by the Fed, and was not revealed during this past weekend’s talk shows."

In questioning Liddy yesterday, Rep. Alan Grayson zeroed in on an item in AIG's 10K which said that if the yield curve expands by a mere 100 basis points, AIG would be on the hook for $500 Billion (that's not a typo) given their current derivatives portfolio.

I wonder if the Fed is hell bent on preventing that, other consequences be damned.

They keep adding floors to the house of cards.

Mar 19 04:34 PM

[MikeH.:]

Good article and excellent comments by Chris B.
Everyone seems to dismiss or not consider global politics. This move is also preliminary to the approaching G-20 economic summit.
Watch Int'l. central bank moves after that meeting. Doesn't this move make the U.S. (Obama) a more confident "Player" (currency, trade, economic partner, etc) -- whether China likes it or not?

Mar 19 05:11 PM

[huskerbob:]

To Chris B and those of a similar mind: The bottom line is that the Fed can lower interest, raise interest, boost liquidity, print money, or any combination thereof. The sum of their actions is only to put off the inevitable. You cannot get something for nothing. They have not figured out how to make money out of thin air. They are simply shuffling papers to create an illusion while those in the know grab as much money as they can. Was Japan being cheap? We are being cheaper, as the Fed is attempting to solve the problem by typing in numbers on a computer screen. If you think that will solve our problems, then you literally believe in magic.
We have had cheap money for too long, leading to a tragic level of malinvestment. It will take a while to undo this, and it will be very painful. Our currency has also been irreparably harmed by decades of mismanagement, so if you want to see another two decades of growth and economic expansion, we will need a painful readjustment. Or move to China.
I will be long the stock market right along with you someday, but there is an enormous amount of economic suffering ahead before that happens, and there is nothing the Fed can do about it. They can inflate away our debt, but our economic catastrophe is written in stone.

Mar 19 05:45 PM

[Sober Realist:]

"..there is an enormous amount of economic suffering ahead before that happens."
----the last 12 months have been extremely painful already. Unwinding this financial mess will take some time. No one is immune. It's a global problem and includes China (estimates of 40 million unemployed):

"China will start doing what it needs to do. It is signaling that it will start pouring resources into its internal economy, modernizing and building infrastructure on a huge scale. It will use up much of its foreign reserves in doing this. But the transformation will have China emerge as a country that trades with itself a lot more than it trades with other countries, just as the US does. The problems that China will face are (a) increasing provincial power relative to the central authorities, (b) building independent entities that regulate internal trade, (c) building internal equity investment mechanisms, and (d) establishing an independent mechanism for civil law practice. So China needs to mature its economy beyond the old export or die model, but in doing so it will have to build a lot of things it doesn't have now. Quite a conundrum."

Don't ever count America out and say her fate is written in stone. She will prove you wrong.

seekingalpha.com/user/...

Mar 19 07:05 PM

[icandoitdon:]

christ, how inane is this?

don't you realize what the federal reserve is doing? they're printing money. and you not only think they should do more of it but stiff those countries who've loaned us trillions. what do you think a dollar would be worth if the fed simply printed it without restriction?

either educate yourself or quit wasting your time on a web site for adults.







On Mar 19 01:57 PM Chancer wrote:

> At least Bernanke is doing something, while Obummer and his "best
> & brightest" dither, hem, and haw.
>
> Since China just expressed concerns, this could be a show that there
> are others buyers.
>
> I think this is interesting because it is like financing our own
> debt. If the Treasury cannot repay the Fed, what are the consequences?
> Fed and Treasury could both write it down with no repay cost to the
> taxpayer. Too bad the Treasury cannot finance all the debt by having
> the Fed buy it- better than repayment to China.

Mar 19 09:04 PM

[The End is ...:]

Good points regarding the TIPS, most commentary has missed emphasizing why that's happening. Actually makes sense to buy those, shows B. isn't a complete and utter fool, but he's close;)

Mar 19 10:14 PM

[andruomail:]

Where are they finding the extra $750 billion of mortgages to buy?? is this the long-awaited bad bank?

Mar 20 12:13 AM

[Vox Rationalis:]

Moon Kil Woong wrote:

> Thus he determined he would artificially manipulate Treasuries by
> threatening to buy them if no one would...

Couldn't be more wrong. I read a paper Bernanke wrote several years ago (can't find the link now) describing a hypothetical where the central bank had moved rates as low as possible and yet needed to do more. He described a strategy of purchasing Treasuries, focusing on those with maturities in the 12-24 month range. This would increase the money supply now, when we need it, and automate its future reduction as the purchased Treasurys are redeemed. The idea was that by targeting these purchases and driving yields down at one point on the curve, the rest of the curve would also move down. Two birds with one stone.

Pretty clever, seems to me. But more importantly, hardly a new or reactionary idea.

> Bernake is still stuck fighting yesterday's war, deflation and falling
> house prices.

Newsflash. House prices are still falling.

> Today's war is jobs losses and
> financing the huge stimulus packages.

Not at all, not for Bernanke. You think we need to start paying for the stimulus now? Is that because you disagree with it in principle? Because we haven't even DONE the stimulus yet. As for jobs, Bernanke's contribution is to win HIS part of the war: healing the credit markets while keeping inflation in check.

> The medicine is a lot worse than the disease.

Read up on the Depression. You might change your mind.

Mar 20 12:17 AM

[Vox Rationalis:]

Something I forgot to mention in response to comments like the author's "America is now purchasing its own debt," which he clearly thought was important and shocking, as he put it in bold face.

Ever hear of Social Security?

It's been accumulating government debt for more than 20 years ($180B last year). That's an agency of the government buying government debt. Is the Fed's announced action really so different?

Mar 20 12:30 AM

[Steven Hansen:]

BS_Detector -

you are right about social security. that seems to be working out well - right?

steven hansen

Mar 20 12:43 AM

[UtopianWorks:]

Perhaps in the history books of tomorrow we will see the Fed actions as response to an incorrectly perceived contraction of credit as the root cause (credit crunch anyone). This is of course the textbook hypothesis on the causes of the Great Depression.

However, it is possible to explain the crisis as a problem coming about from a sharply reduced demand for debt....

After real wages went down and never recovered in real terms, since the late 90s, the consumer turned out to debt to keep and expand its standard of living. To keep the engine of growth running, Mr. Greenspan obliged with low rates, and securitization allowed Wall Street to provide near limitless credit (and create several asset bubbles in the meantime).

But now after the housing bubble burst, the consumer is tremendously over-extended... and has clamped down and will remain for a while. In fact, consumption might not increase to previous high levels till real wages climb or the population increases enough (that will take a while...)

In this scenario (and we will find if it is right) the Fed's actions might have little to no effect in terms of growth as the consumer will not eagerly eat up much debt, even if debt is cheaply available.

Significant inflation (or deflation) will probably only further damage the consumer and recovery.

This is a Grand Experiment, but we are the Guinea Pigs!

Mar 20 01:14 AM

[Conan the B...:]

The next Government Auction could turn out to be a Total Bust....No bidders.

At any point in time, the Government can change its mind on the Debt it is issuing. They can impose conditions on its use, they can backdate those conditions. Illegal? By whose Laws? We make the Laws.


BUY GOLD, BUY Silver. Get Rid of your paper dollars as soon as you can. They are covered by the Full Faith of the US Government.

That's the Problem.

Mar 20 06:12 PM

[Vox Rationalis:]

> you are right about social security. that seems to be working out
> well - right?

Sarcasm, right?. Well, the answer is yes, fairly well, and as expected. Good thing it didn't get invested in the stock market over the last couple of years, don't you think?

It also happens to provide another example of why the notion that the Fed wants to inflate the debt away is utter fantasy - with U.S. Government agencies holding 45% of the U.S. debt, who's the biggest loser if this happens?

Mar 20 08:26 PM

[Vox Rationalis:]

UtopianWorks wrote:
> After real wages went down and never recovered in real terms, since
> the late 90s, the consumer turned out to debt...

Recently, every time I've seen the "real wage stagnation" argument, I've wanted to research a little on the cost of healthcare. So I've looked up a couple of data points, and though this isn't at all rigorous, it is interesting if only barely relevant to this thread. My apologies if you're annoyed by the distraction.

According to the Kaiser Family Foundation, from 1999 to 2008, real wages fell, as inflation over the period was 44% while the median wage only increased 29%. But, during the same period, the average cost of employer-provided health insurance for a family of four increase by 120%, and employers are paying a larger share. Crunching the data a bit, I found that when the increase in the employers' contribution to health insurance is included, compensation over the 99-08 period increased more than 41%. Still a bit less than the rate of inflation, but certainly better.

So the real drag on wages during this period of time is healthcare. Comparing median wages less average insurance and out-of-pocket costs, workers' compensation lagged inflation by 20% from 1999-2008. Extrapolating from this isn't simple, however, because individual results will rarely be this poor - a person at the median in 1999 is not likely to STILL be at the median in 2008.

Mar 20 09:29 PM

[Steven Hansen:]

yes vox rationalis, your concerns about health care are on target - and it is a major economic drag even more so than taxes. except for the highest income groups, it is diverting a significant portion of what would be disposable income.

steven hansen

Mar 20 11:35 PM

[Conan the B...:]

If you think in terms of The unfulfilled dreams of the Great Society, you should be able to get an idea where all "roads" lead.

Given the Goals of the Great Society, Obama's "stimulus" package makes sense and the inflamation of Anti-Corporate sentiment is a necessary tool to get the Public to go along.

IMHO

Mar 21 09:54 AM