Fed begins monetizing the deficit

By Numerian

The Federal Reserve, in announcing the results of this week's meeting of the Open Market Committee, surprised the market by revealing it will begin purchasing US Treasury notes and bonds with the principal income it receives from its vast holdings of Fannie Mae and Freddie Mac mortgage securities. This practice - wherein the Fed buys up US government securities and injects cash into the public market as payment for these securities - is a form of monetizing the debt.

The last time the Fed did this on a big scale was back in the 1960s when it attempted to mop up the excess Treasury securities that were flooding the market as a result of Lyndon Johnson's efforts to finance the Vietnam War. That Fed program was viewed at the time as a failure, since the cash the Fed put back into the economy in exchange for the securities was a big reason - perhaps the major reason - why price inflation accelerated from the late 1960s until a decade later, when Paul Volcker managed to squelch inflation once and for all with forbiddingly high interest rates.

Fraught with risk

The market was expecting some sort of monetary stimulus, but not this. The expectation was that the Fed would renew its "quantitative easing" program involving Fannie Mae and Freddie Mac securities - a program designed to push down long term mortgage rates. That program was successful inasmuch as mortgage rates are at record lows, but it left the Fed with well over a trillion dollars of these securities on its balance sheet. Fed officials have lately been pondering publicly how to get rid of these securities, and apparently have concluded they can't under present market conditions without forcing mortgage rates back up again, which would only hurt the housing market. Instead, these officials have concluded that the Fed has no choice but to hold on to these securities until they mature, which is well over 10 years from now for the portfolio.

The Fed receives billions of dollars of principal and interest payments every year on this portfolio, and what to do with this cash has always been open for discussion until now. But using principal proceeds from these securities to monetize the government debt is fraught with risk. For one, should the housing market start to weaken again and foreclosures rise from current levels, the Fed will be sitting on billions of dollars of credit losses on its portfolio. This could eat up most if not all of the profit it would otherwise earn on this portfolio. Second, older investors have memories of the nasty inflationary consequences the last time the Fed monetized the debt, and the market has become very skittish about the risk of inflation, and maybe even hyperinflation ala Weimar Germany, that could result from the enormous fiscal and monetary stimulus put into the economy since 2007.
Deflation
In terms of these risks, the best thing the Fed has going for it at the moment is that the pricing problem facing the current economy is not inflation, but deflation. A growing number of economists, and even some Fed governors, are worrying outright about deflation, but at least in a deflationary environment the Fed is given a lot more leeway to monetize the debt and build up its balance sheet as a consequence. The Fed press release today did not mention deflation per se, but the FOMC no longer described the economy as "progressing", as it did in June. Instead, the Fed sees an economy with substantial slack, a stagnant housing market, repressed earnings power for workers, and very low inflation.

The bond market was happy to buy Treasuries on this news, concentrating in the 2 to 10 year maturities, in anticipation of higher prices (and thus lower yields) once the Fed begins actively purchasing. So far, in other words, the bond market sees no risk of inflation, much less hyperinflation, and is content to see yields continue to head to record low levels. Such excessively low yields on government bonds have only been seen in deflationary economies like Japan has experienced for nearly two decades. This is in essence what the bond market is forecasting for the US economy.

The stock market, which has been on a tear since early July, took this news in stride, but time and past experience is weighing heavily on this stock rally. When bond yields fall to record lows, this has never boded well for equities. In a deflationary economy, stock prices are one of the main victims, and the US stock markets have so far shown no significant adjustment downwards to reflect deflation. Stocks may have some serious "catching up" to do.

At the least, we can say we are no longer in that environment in the spring when Fed governors were talking seriously about how they were going to remove all their monetary stimulus now that the economy has recovered. Instead, we are witnessing yet another round of monetary stimulus, a recognition by the Fed that their previous efforts have failed to ignite a sustainable recovery.

See attachment: Federal Reserve Press Release - Open Markets Committee Release Date: August 10, 2010

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FedOpenMarketCommitteeAug10.pdf25.38 KB

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Comments

I read that tomorrow

the actual amounts will be announced. It's pretty amazing because the Fed is claiming they will "help" the economy, when this won't do anything for jobs.

Did you see the election results today? Bennet has an atrocious voting record on legislation in favor of the U.S. middle class, jobs and I don't know that much about CT but it doesn't look too good.

Instead of getting representatives who are less corrupt it seems we're getting either a choice of the real crazies, (UT) or the bought and paid fors.

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Fed's Action Are Deflationary

The Fed is selling Mortgage backed and all Asset classes and turning proceeds into Long Term Treasuries. This is great arbitrage but terrible for the economy. The attachment proves that 1) the size of the balance sheet is smaller in all classes but Treasuries and 2) Treasuries are the only asset class growing.

I am not willing to defend the further inflation of housing. There are a thousand other asset classes besided Mortagage backed paper. But all asset classes are shrinking. This has to be deflationary. Even the premise the Fed is using is deflationary per se: lowering interest rates. Mike is right.

 

Date Traditional Security Holdings Long Term Treasury Buys Financial Institution Lending Key Credit Markets Chg Agency Mortgage-Backed Sec Purchase
1/3/2007 771569   88047 0 0
1/10/2007 775795   69095 0 0
1/17/2007 777708   68484 0 0
1/24/2007 777213   60369 0 0
1/31/2007 777579   67405 0 0
2/7/2007 776052   65920 0 0
2/14/2007 777917   69135 0 0
2/21/2007 776444   75274 0 0
2/28/2007 777065   76583 0 0
3/7/2007 778604   73767 0 0
3/14/2007 778560   73687 0 0
3/21/2007 779210   72386 0 0
3/28/2007 780301   72236 0 0
4/4/2007 778991   74031 0 0
4/11/2007 780336   69573 0 0
4/18/2007 781361   70640 0 0
4/25/2007 782129   68673 0 0
5/2/2007 783936   83260 0 0
5/9/2007 786752   67232 0 0
5/16/2007 786550   62197 0 0
5/23/2007 785997   64917 0 0
5/30/2007 786033   68969 0 0
6/6/2007 784360   74214 0 0
6/13/2007 786772   63952 0 0
6/20/2007 785699   67289 0 0
6/27/2007 787147   61329 0 0
7/4/2007 780390   78066 0 0
7/11/2007 787374   66530 0 0
7/18/2007 785962   68424 0 0
7/25/2007 786062   64876 0 0
8/1/2007 784674   73856 0 0
8/8/2007 787327   63829 0 0
8/15/2007 785954   82772 0 0
8/22/2007 784532   67863 0 0
8/29/2007 779362   70730 0 0
9/5/2007 773755   83285 0 0
9/12/2007 774120   82046 0 0
9/19/2007 777459   75020 0 0
9/26/2007 776315   83629 0 0
10/3/2007 775901   86653 0 0
10/10/2007 776557   82402 0 0
10/17/2007 773723   85762 0 0
10/24/2007 773131   86313 0 0
10/31/2007 771470   91893 0 0
11/7/2007 772354   92772 0 0
11/14/2007 771535   95064 0 0
11/21/2007 770663   98193 0 0
11/28/2007 771677   98429 0 0
12/5/2007 773958   93648 0 0
12/12/2007 766809   97799 0 0
12/19/2007 758996   112265 0 0
12/26/2007 740475   133936 0 0
1/2/2008 724107   168235 0 0
1/9/2008 718496   150798 0 0
1/16/2008 721165   146678 0 0
1/23/2008 712865   150055 0 0
1/30/2008 706841   158627 0 0
2/6/2008 701397   161677 0 0
2/13/2008 703622   156056 0 0
2/20/2008 697345   170965 0 0
2/27/2008 698899   168607 0 0
3/5/2008 694345   180510 0 0
3/12/2008 697494   172745 0 0
3/19/2008 664666   215775 0 0
3/26/2008 619037   251653 0 0
4/2/2008 503479   373111 0 0
4/9/2008 451112   416119 0 0
4/16/2008 410205   458124 0 0
4/23/2008 378971   490878 0 0
4/30/2008 385300   481391 0 0
5/7/2008 377491   492452 0 0
5/14/2008 369513   498788 0 0
5/21/2008 371762   500605 0 0
5/28/2008 378343   500218 0 0
6/4/2008 371291   507714 0 0
6/11/2008 375350   499567 0 0
6/18/2008 359344   519867 0 0
6/25/2008 366701   508925 0 0
7/2/2008 361356   499405 29816 0
7/9/2008 369150   490922 28900 0
7/16/2008 374734   485116 28955 0
7/23/2008 362533   493133 29025 0
7/30/2008 352521   513550 29065 0
8/6/2008 346432   516110 29105 0
8/13/2008 348242   509936 29145 0
8/20/2008 354689   506921 29183 0
8/27/2008 333430   525036 29213 0
9/3/2008 328606   538042 29253 0
9/10/2008 311701   550510 29293 0
9/17/2008 304146   600227 29333 0
9/24/2008 271610   808868 51133 3714
10/1/2008 220811   1008116 151517 11929
10/8/2008 265250   1040817 175342 14347
10/15/2008 256154   1311702 159108 14105
10/22/2008 253398   1393492 143356 14105
10/29/2008 253919   1438859 167530 13897
11/5/2008 255814   1443203 344587 13565
11/12/2008 258094   1571392 357030 13155
11/19/2008 270934   1534238 362434 12654
11/26/2008 280096   1428042 372453 12261
12/3/2008 229310   1479477 397659 12057
12/10/2008 236321   1590947 397355 13106
12/17/2008 239033   1562440 408560 16587
12/24/2008 291501   1444750 425690 19927
12/31/2008 296299   1471568 431230 20266
1/7/2009 306157   1402649 431037 19587
1/14/2009 334820   1272890 427103 21900
1/21/2009 334579   1239063 439301 29942
1/28/2009 342748   1211148 404503 33492
2/4/2009 348040   1109586 348510 36406
2/11/2009 351544   1098632 343329 39208
2/18/2009 353377   1123811 336386 95629
2/25/2009 356844   1111470 329857 104398
3/4/2009 321754   1140934 323929 107114
3/11/2009 327313   1123188 320217 109418
3/18/2009 329650 286 1119269 322472 271958
3/25/2009 345998 327 1100090 320948 285760
4/1/2009 376921 18563 1040126 328050 287277
4/8/2009 405314 34645 1008090 332438 291399
4/15/2009 408576 48823 968422 330108 344975
4/22/2009 422292 57685 945815 320322 425356
4/29/2009 432574 71760 846842 304841 433802
5/6/2009 431916 84337 839356 252605 435414
5/13/2009 430578 100826 864110 266867 456224
5/20/2009 431082 112766 851266 267034 505034
5/29/2009 438024 128085 740865 258801 510655
6/3/2009 437118 135134 739433 248099 508316
6/10/2009 424625 157653 692646 241706 511272
6/17/2009 438863 167911 664836 241485 543161
6/24/2009 442671 182434 582096 231937 559227
7/1/2009 446005 192512 569312 221781 559332
7/8/2009 455807 202539 547975 213089 560277
7/15/2009 449567 213082 555483 207182 588545
7/22/2009 454174 220840 493525 204702 639475
7/29/2009 460530 223869 492092 186762 648573
8/5/2009 459666 232899 479800 157752 649725
8/12/2009 451132 256530 480470 151500 651781
8/19/2009 446152 270825 447237 154589 717782
8/26/2009 447315 279606 435376 149755 738453
9/2/2009 447992 288173 439496 147079 742597
9/9/2009 448394 293107 436616 145532 747833
9/16/2009 453715 294455 418992 148756 774694
9/23/2009 450996 300247 419756 147244 816121
9/30/2009 454473 302609 396368 146291 822246
10/7/2009 455958 302631 392535 144863 825716
10/14/2009 457180 306903 361903 145012 837119
10/21/2009 459112 306956 359348 143742 904409
10/28/2009 460214 308029 335157 135806 917626
11/4/2009 458990 310808 335305 124256 921413
11/11/2009 459404 310815 301688 122397 922949
11/18/2009 450358 318693 302904 123737 997429
12/2/2009 448953 318351 282155 124726 1007222
12/9/2009 449853 318360 243163 123570 1009738
12/16/2009 449859 317807 243204 125514 1030772
1/6/2010 442627 316370 239246 126639 1068362
1/13/2010 450529 316377 229837 125890 1079714
1/20/2010 452176 318215 181426 126031 1129581
2/10/2010 454235 317889 181313 120133 1136822
2/24/2010 446183 325295 155704 119776 1198727
3/3/2010 448784 322266 154033 119698 1194300
3/10/2010 448939 322299 154482 118030 1195177
3/17/2010 448184 323209 141816 120720 1234884
3/24/2010 449211 323243 139984 120505 1241007
3/31/2010 447232 322335 139464 119921 1237597
4/7/2010 448492 322338 137781 119757 1237701
4/14/2010 447841 322340 136871 119486 1247188
4/21/2010 445608 325157 135181 119591 1268768
4/28/2010 445630 325159 135676 120092 1268666
5/5/2010 449721 321694 134723 115849 1265522
5/12/2010 451811 321733 134882 112100 1265691
5/19/2010 444166 328569 141692 111973 1288710
5/26/2010 444839 328608 128956 111864 1285309
6/2/2010 449317 321837 132434 111665 1280323
6/9/2010 449805 321854 126654 111019 1280366
6/16/2010 449689 322275 127264 110854 1287561
6/23/2010 451257 322293 125695 110605 1294123
6/30/2010 447588 322113 127715 110024 1284520
7/7/2010 447833 322120 127601 109755 1283034
7/14/2010 448094 322127 128723 109113 1283477
7/21/2010 450396 322158 125672 108704 1284224
7/28/2010 450848 322166 125087 108371 1281212
8/4/2010 450315 322630 125251 109334 1277010

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