Seeking Alpha
Bonds, dividend investing, ETF investing, currencies
Profile| Send Message|
( followers)  

Monetary policy is a powerful tool due to the explicit control the Fed has over the interest rate paid on short-term instruments. In a normal economic environment a cut in the overnight rate would help generate demand for loans and result in economic growth via the interest rate channels. This control over the short end of the curve generally extends through the entirety of the curve to varying degrees. Thus, theoretically, the Fed can always generate demand for debt regardless of the loan duration. If we were not in a balance sheet recession I presume monetary policy would be more effective than it has been.

The beauty of controlling the overnight interest rate is that the Fed actually controls it. When the Fed sets its interest rate target for overnight loans (at the much hyped FOMC meetings) it is essentially warning the market that it's willing to buy all outstanding paper at that rate. In other words, bet against us if you dare! This is not exactly the same as what they’re doing under QE2. Although they’re simply buying longer dated securities they are not explicitly telling the market that they are willing to buy whatever amount it takes in order to meet a specific rate.

When Ben Bernanke initiated his policy of QE2 he explicitly stated that his intention was to suppress long-term rates and create demand for loans. What he’s done instead is create a panic about inflation and money printing. In the end, there is little evidence that QE2 is having any sort of positive effect. It has not driven the dollar down, there is no such thing as a wealth effect in the stock market and input costs have surged. Most importantly, however, it has failed spectacularly in keeping rates low.

The problem here is that the Fed doesn’t truly control the long end of the curve because it effectively allows the market to set long-term interest rates. As you can see below the market has essentially taken the other side of the Fed’s position since the Jackson Hole Speech. In other words, the Fed is failing miserably in its efforts to suppress long-term rates. QE2 is still not working.

Click to enlarge

(5, 10 & 30 year bond rates)

In order for the Fed to keep long-term rates at a target rate it would need to target that rate explicitly and be willing to bid at that level no matter what. It would essentially be taken by the media as “QE ad infinitum” and I personally think Ben Bernanke is terrified of the potential impacts of such a policy or simply does not even understand that this is what’s required. Since bonds don’t fund the U.S. government we could also stop issuance of long-term bonds and allow the Fed to step up and effectively buyback all outstanding long-term debt at whatever price it desired. But again, the public would likely be outraged as the media and supposed “monetary experts” would tell us all that this was “debt monetization” and “money printing." Who knows what the response would be in this environment? Oil could be at $150 before you bat an eyelash. Therefore, any such move would have to be measured and gradual.

The most important point is, without such a measure, the Fed will continue failing in its attempts to control long-term rates and QE2 will continue to have little to no positive impact on the overall economy.

Source: QE2 Not Suppressing Interest Rates