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The Federal Reserve announced last week that it will engage in a policy called "the twist" - meaning it will sell some of the short-term U.S. treasury holdings in exchange for long-term U.S. treasuries. This is said to be neutral to the money supply and therefore not inflationary, but let’s take a closer look at the consequences of this action.

Suppose the Fed did not announce this program and the treasuries held by the Fed, with maturities ranging from a matter of months to three years, stayed on its balance sheet. What would happen? Well, when they matured and the U.S. Treasury had to come up with the cash to pay back the principal, this would most likely just get refinanced at the current rates. No new Federal Reserve notes are created in this process. The date of repayment is simply pushed further into the future and a new interest rate is imputed on the debt. The Fed literally creates money and therefore can never experience a liquidity crisis and so would never have any pressing need for cash.

Now let's look at what happens under the current scenario where the short term debt is now being held by dozens or hundreds of private investors. Many of the recipients of the short term treasuries are going to be banks, which are facing a huge liquidity crisis. They need cash and they need it now in order to remain solvent. So it's unlikely that this debt is going to be refinanced. When these treasuries mature, the principal is going to have to be repaid. But with a $1.6 trillion annual budget deficit, the government hasn't exactly planned for the repayment of this money. They will have to find other lenders and this will most likely come in the form of increased Treasury bond purchases by the Fed, which is inflationary.

The Fed has also announced that it will start purchasing more mortgage-backed securities at the expense of U.S. treasury purchases. This can only be a symbolic gesture toward the failing housing market. Interest rates are still at historic lows but no recovery is in sight. Bernanke is firing every gun in his arsenal, in every direction, but is still not hitting the target. It must be a tough time to be the head of the world's most influential central bank. Day after day, the god-like powers central bankers assumed they had are giving way to the reality that they're just money-printers, completely impotent at effecting any real improvement to economic conditions.

An article in the Wall Street Journal yesterday says it all:

"The Fed announced that through June 2012 it will buy $400 billion in Treasury bonds at the long end of the market - with six- to 30-year maturities - and sell an equal amount of securities of three years' duration or less. The point, said the FOMC statement, is to put further "downward pressure on longer-term interest rates and help make broader financial conditions more accommodative."

It's hard to see how this will make much difference to economic growth. Long rates are already at historic lows, and even a move of 10 or 20 basis points isn't likely to affect many investment decisions at the margin. The Fed isn't acting in a vacuum, and any move in bond prices could well be swamped by other economic news. Europe's woes are accelerating, and every CEO in America these days is worried more about what the National Labor Relations Board is doing to Boeing than he is about the 30-year bond rate.

The Fed will also reinvest the principal payments it receives on its asset holdings into mortgage-backed securities rather than in U.S. Treasuries. The goal here is to further reduce mortgage costs and thus help the housing market. But home borrowing costs are also at historic lows, and the housing market suffers far more from the foreclosure overhang and uncertainty encouraged by government policy than it does from the price of money.

The Fed's announcement thus had the feel of an attempt to show it is doing something to help the economy, even if it can't do much. The current 10-member FOMC also reported three dissenting votes from regional bank presidents, who also dissented from its August decision to declare that short-term interest rates will stay near-zero through mid-2013."

With the economy ailing, the Fed is trying everything it can to keep the stock, housing and U.S. debt markets afloat. As the sovereign debt crisis continues to spread throughout Europe it will reach epidemic proportions. Already we're hearing demands for inflation in order to make repayments easier. With these demands, the desperation of these monetary and economic engineers is becoming more and more overt. Resorting to inflation in order to repay huge debts has been the final act of every empire, state and banana republic the world has ever known. From Weimar to Zimbabwe, even "just a little inflation" has turned in to a lot when the public realizes that the money system is being gamed for the benefit of big government and big banks. Inflation begets more inflation, as the price-level indexed government pension and benefit liabilities grow with every successive injection of money.

Former Fed Chairman Paul Volker, who actually managed to avert an inflationary catastrophe by doing the exact opposite of what Bernanke is doing, couldn't have said it any better in a recent New York Times article:

So now we are beginning to hear murmurings about the possible invigorating effects of “just a little inflation.” Perhaps 4% or 5% a year would be just the thing to deal with the overhang of debt and encourage the “animal spirits” of business, or so the argument goes.

It’s not yet a full-throated chorus. But remarkably, at least one member of the Fed’s policy making committee recently departed from the price-stability script.

The siren song is both alluring and predictable. Economic circumstances and the limitations on orthodox policies are indeed frustrating. After all, if 1% or 2% inflation is OK and has not raised inflationary expectations - as the Fed and most central banks believe - why not 3 or 4 or even more? Let’s try to get business to jump the gun and invest now in the expectation of higher prices later, and raise housing prices (presumably commodities and gold, too) and maybe wages will follow. If the dollar is weakened, that’s a good thing; it might even help close the trade deficit. And of course, as soon as the economy expands sufficiently, we will promptly return to price stability.

Well, good luck.

Good luck indeed, Mr. Bernanke. As for me, I'll be taking advantage of the lower gold and silver prices to expand my position and profit from the monetary lunacy that's crippling the global economy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: A Twisted QE3