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Joe Barbieri has Bachelors' degrees in both Civil Engineering and Commerce from the University of Toronto. He has worked in the Financial Services field for over 13 years, with over 10 years on the institutional side of the business. He has covered positions from Fund Accounting to Investment... More
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  • What If The Fed Loses Control Of Interest Rates? 0 comments
    Feb 14, 2013 11:37 AM

    The Fed has stated for years now that interest rates will be held at ultra-low levels. What if they can't achieve this? Looking at the history of the Fed, this is not a likely scenario. Does this mean that a loss of control is not possible?

    There are a series of assumptions here which can now be called into question.

    The Fed only controls the overnight rates. Any other interest rates are controlled by the bond markets. This means that these markets have to be convinced that interest rates can in fact stay low. If they are not, they will sell the bonds and drive up the yields. Should this happen, the Fed may be pressured to raise interest rates to coincide with what the market believes, or will have to buy all of the longer term bonds. The Fed has actually been doing the latter, which is how the interest rates have been kept so low across the board. How are they doing this? Bonds are being purchased with more debt, and the interest will get added to the deficit and debt of the US government. At some point, will someone ask whether this debt can be repaid? This question has been asked by many people.

    The second assumption is that debt is being manufactured in currency units, in this case US dollars. What would happen if the debt was rejected? Since the Fed is buying a lot of its own debt, this is not likely to happen. The casualties will be felt with the currency itself. If so many dollars are being circulated to pay for all of this debt, and nothing else is changing, the value of the currency will plunge. The ultimate effect will be as if someone tried to pay debt in German Marks instead of Euros. The receiver would simply refuse the payment as they would want Euros instead, and the borrower would be in default. A debt can only be absolved if both parties agree to the terms.

    The government is assumed to have unlimited taxing power, and by consequence, can always pay its bills. How are the bills being paid? They are being paid with paper that may not be trusted in future. If a million pieces of monopoly money were used to pay taxes, this would not be beneficial. This is a very similar scenario if the government pays its bills, but the means of payment is deemed to have no value.

    How likely are these assumptions to fall apart? Not very, but the possibility exists.

    Sources:

    1) https://mninews.marketnews.com/content/repeatofflsothers-doubt-fed-can-hold-zero-ffr-ylds-rise-2

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

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