The Fed's Dilemma

by: Diffusion

Fed's Operation Twist kills three birds with one stone. First it helps to inject liquidity into the financial system. Second it helps to manage long term inflation expectation by lowering yield of long term bonds. Third the low yield means low borrowing cost for the Department of the Treasury.

Everything works out nicely in a low growth low inflation environment. But the water is murky when the stock market buys the growth story.

Recent rally is driven by investor's growth expectation as discussed in a previous article. Evidently, the Nasdaq composite index, which contains a lot of high-tech names and is considered to represent the growth, is the strongest this year among all major indices.

As a result of the dramatic move in the past couple of days, the Nasdaq composite index pushed up to a multi-year high and the yield on the 30-year bond witnessed a mighty breakout to the upside. All of a sudden, two birds out of the three flew away --- long term inflation expectation and borrowing cost jump up.

Inflation is not that bad if the economy is in solid growth. And more often than not, inflation is a by-product of economic growth. But the rising borrowing cost is a big problem. I don't need to mention numbers of the huge and ever growing debt of the US. It's critical that the Treasury Department be able to keep borrowing from the market at low cost. Otherwise … You don't want to hear that.

The medicine prescribed by the Fed is capable to handle only two scenarios:

  • low growth, low inflation, and low borrowing cost
  • solid growth, moderate inflation, and manageable debt

The optimal route is that we can migrate from the first scenario to the second without any glitch. Investors better hope that the growth story they are buying is real and strong enough to pull the US out of the deep debt hole. If not, we may end up in the middle of nowhere: low growth, high inflation, and high borrowing cost. Mr. Bernanke will scratch his head really hard if that happens.

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