Saturday, September 24, 2011

Trying to Have It Both Ways

The Federal Open Market Committee announced that it would do the twist.  In particular, they announced that they would sell $400,000,000,000 in short term (30 days to three years) U.S. treasury securities, and purchase the same amount of long term (6-30 years) U.S. treasury securities by next June.  This is meant to influence long term interest rates, as to stimulate investment in things such as mortgages.

What was very telling for me is that they left the federal funds rate target at 0-.25%.  The Federal Reserve performs open market operations to keep that rate at its target usually by entering into repurchase agreements on short term treasuries (usually 30 days) because that is what they consider to be the best way to remain flexibly sensitive to target fluctuations.  If they decide that the monetary base is likely to depreciate for a substantial amount of time, then they purchase bonds outright.  They've already been flat out buying bonds, and now they're buying longer term bonds, because they believe that they will need to keep the monetary base larger for a long period of time.

The Eccles Building (photo: Margit Myers)

The problem with 'the twist' is that long term treasury securities don't directly compete with federal funds.  They are different loans that attract buyers for different purposes.  So while these actions may directly increase the monetary base in the same way that the Fed is used to, they may have less of an impact on the federal funds target rate.  Essentially, the Fed is trying to have it both ways and influence both short and long term interest rates.  If the target rate changes because of all of this selling, what will the Fed do?  The Fed will likely buy more short term securities to put downward pressure on the Federal Funds target rate.

So while the Fed says that they are buying long term securities, and I certainly believe that they will buy 400 billion dollars worth.  I am not so sure that they will sell all of the 400 billion if those actions influence the Federal Funds rate to rise above the target.

I think all of the fanfare surrounding this 'twist' is actually a smoke screen to try and please two different constituencies.  On the one hand, they want to the markets to believe that they are performing stimulative measures, and on the other hand they want those wary of inflation to believe that they are not really performing stimulative measures.  Again, they are trying to have it both ways.

Another byproduct of these actions is that the Fed has made the job of quickly shrinking the monetary base a bit harder.  This will already be a difficult job if inflation ever gets out of hand.  Much of the assets that they've bought are those so-called toxic mortgage backed securities that will be very difficult to unload off of their balance sheet, and now they are loading up on longer term assets.  These treasuries will probably not be hard to sell to the market, but they won't be quite as easy as just letting them expire.  Of course, one also wonders how much the Fed needs to buy treasuries or how much the Treasury department needs the Fed to buy treasuries.

The Fiery Furnaces - "Benton Harbor Blues"

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