Fed begins monetizing the deficit - buying U.S. Treasuries

**Blue** · 12 Aug 10,, 15:36

Is this a good idea? I doubt it.

Posted on Wednesday, August 11, 2010 2:42:43 PM by Marie

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.

Fed begins monetizing the deficit - buying U.S. Treasuries

**astralis** · 12 Aug 10,, 15:52

there's no good choices, just less bad ones.

on the flip hand side, given the serious deflationary pressures we're facing, this sort of squelches all those deficit inflationary fears everyone was screaming about several months back.

**highsea** · 12 Aug 10,, 17:59

So much for Bernanke's plans to shrink the Feds balance sheet. China will love this, lol.

$200 Billion a year won't have any effect in interest rates if past experience is any clue. But it's an admission the Obama stimulus has failed to stimulate consumer demand. The Fed has bought up over $1.4 Trillion in mortgages and had already pumped $300 Billion into the treasury to try to reassure the markets, interest rates only dropped 1/2 point.

Another dismal labor report this week, and the train wreck continues....

Time to start buying TIPS.

**astralis** · 12 Aug 10,, 19:09

uh, exactly what signs of inflation do you see on the market right now?

**highsea** · 12 Aug 10,, 19:17

Originally Posted by astralis

uh, exactly what signs of inflation do you see on the market right now?

I asked you this before and didn't get an answer. What is responsible for the price of gold?

We are not seeing inflation right now because the economy is at a standstill. Presumably at some point that will end, but hey- maybe not. But if it starts growing, it wouldn't be a stupid move to hedge against inflation, considering the Fed's doubling of the money supply.

But like everyone else, right now I can do nothing but find a comfy chair, grab a beer, and watch the train wreck. Hey, maybe we'll go back to a barter economy, who knows?

All the Kings Horses, etc...

**astralis** · 12 Aug 10,, 19:23

What is responsible for the price of gold?

gold is highly speculative to begin with; just because gold goes up because of insecurity doesn't mean other prices will.

Presumably at some point that will end, but hey- maybe not. But if it starts growing, it wouldn't be a stupid move to hedge against inflation, considering the Fed's doubling of the money supply.

right now the main threat to growth is deflation-- considering the tremendous slack in the economy i think worrying about inflation when the house is burning from deflation is off the mark.

**highsea** · 12 Aug 10,, 19:51

Originally Posted by astralis

gold is highly speculative to begin with; just because gold goes up because of insecurity doesn't mean other prices will.

And yet, other prices are going up.

Originally Posted by astralis

right now the main threat to growth is deflation-- considering the tremendous slack in the economy i think worrying about inflation when the house is burning from deflation is off the mark.

Deflation is burning the house?

I think the overall inflation rate as of the end of June was just over 1%. The main reason it's so low is probably falling real estate prices.

A low rate in one area doesn't mean that there is no inflation in other areas. Look at energy, apparel, medical costs, education costs- you will see inflation rates from 2-19% in the 12 months ending June 2010.

**astralis** · 12 Aug 10,, 20:21

highsea,

And yet, other prices are going up.

show me. page 1-3 is a good summary.

http://www.bls.gov/cpi/cpid1006.pdf

for instance:

Energy
The energy index declined 2.9 percent in June, the same decline as in May. The gasoline index declined 4.5 percent in June, its
fifth consecutive monthly decline after nine consecutive monthly increases. The household energy index declined 1.6 percent in June,
its largest decline in over a year. The fuel oil index fell 3.2 percent and the electricity index declined 2.2 percent, more than offsetting
a 0.6 percent increase in the natural gas index. The energy index has increased 3.0 percent over the last 12 months. The gasoline index
has risen 3.9 percent over the last 12 months, with the index for household energy up 1.6 percent.

if you look around page 93, you get a historical comparison, if you look around page 4, a more immediate comparison. in neither case do i see shocking signs of inflation across the board-- if anything else, it's been deflation from the last three-six months in most categories.

**Zinja** · 12 Aug 10,, 22:44

On a brighter side, would this not reduce the deficit, at least somewhat?

**highsea** · 12 Aug 10,, 23:07

Originally Posted by astralis

show me. page 1-3 is a good summary.

No need. You're showing yourself.

...The energy index has increased 3.0 percent over the last 12 months. The gasoline index has risen 3.9 percent over the last 12 months, with the index for household energy up 1.6 percent.

If you look at the 12 month of fuel oil, it's up 16.6%.

Originally Posted by astralis

...in neither case do i see shocking signs of inflation across the board-- if anything else, it's been deflation from the last three-six months in most categories.

And oddly enough, I never claimed "shocking signs of inflation". I think my words were:

We are not seeing inflation right now because the economy is at a standstill

I believe it was you that claimed deflation was "burning the house". If you look at those energy indexes over the 12 months, which was what I was referring to, you will see they are all up. Looking at summertime pricing only, at a time when no one has the money to go anywhere, and comparing it against several months of previous inflation, well....

In fact, most of the recent short term CPI decline is due to gasoline prices.

The inflation rate in the United States was 1.10 percent in June of 2010. Inflation rate refers to a general rise in prices measured against a standard level of purchasing power. The most well known measures of Inflation are the CPI which measures consumer prices, and the GDP deflator, which measures inflation in the whole of the domestic economy.

US Consumer Prices Dip for Third Month
Published: 7/18/2010 9:02:14 PM By: TradingEconomics.com, AFP

American consumers saw prices fall for the third consecutive month in June on the back of lower gasoline costs, the government said Thursday amid concerns over deflation.

The Labor Department said its consumer price index, the most closely watched inflation barometer in the United States, dropped 0.1 percent for the month after falling 0.2 percent in May, the largest decline since December 2008. On a year-over-year basis, consumer prices were up 1.1 percent in June.

Much of the decline was due to weaker gasoline prices. Food prices have remained unchanged for the past two months, according to the Labor Department data.

The core CPI, which excludes volatile food and energy prices and is closely watched by the central bank in considering interest rates, rose 0.2 percent, after a 0.1 percent climb in May.

United States Inflation Rate

So let's see. The gov't wants to monetize the debt, we need an excuse. I know! Deflation!

**astralis** · 13 Aug 10,, 02:58

If you look at the 12 month of fuel oil, it's up 16.6%.

hardly representative (either of deflation or inflation); fuel oil as a commodity is subject to a lot of outside shocks and factors past supply/demand. that's why they exclude the food and energy prices.

I believe it was you that claimed deflation was "burning the house".

more specifically, a japanese-style deflationary trap. the graph below takes away the volatile food and energy prices, and voila....let me see...which fear should we worry about the most, inflation which MAY happen with a recovery years from now, or, given the current data, a much more likely deflationary trap which could happen in a few months?

it's clear that deflationary pressure is an immediate problem while inflationary pressure a la the deficit is a medium/long-term one. solve the first, THEN solve the second.

**highsea** · 13 Aug 10,, 03:22

Lol. fuel oil is volatile, gold is speculative. Everything that is showing inflation is explained away....

Let's hit the panic button over 2 or 3 months of gas prices going down after the normal, annual memorial day peak.

I can plot the same data on a diffferent scale and make it look like a flat line. The graph doesn't even go to zero. That precipitous drop was 1%.

There's no "there" there.

No deflation, just talk.

We'll provide some cover for the Fed to shore up the treasury against the government's fears that our lenders will start asking for more interest on our borrowing. Can't really have that, can we? It might put a damper on our spending sprees.

I don't think China will buy it.

**astralis** · 13 Aug 10,, 04:15

highsea,

Everything that is showing inflation is explained away....

yeah-- pick better examples next time. if core CPI goes up significantly, then we know there's an inflation problem.

I can plot the same data on a diffferent scale and make it look like a flat line. The graph doesn't even go to zero. That precipitous drop was 1%.

by core CPI standards, that IS significant. take a look at the historical movement.

No deflation, just talk.

which is ironically the same as your inflation fears. only given the trend lines, it does seem to be moving closer to deflation than inflation, don't you think?

We'll provide some cover for the Fed to shore up the treasury against the government's fears that our lenders will start asking for more interest on our borrowing.

not sure if that's the government's fears, considering the trendlines for the 10-year bond rate.

10-year bond rate, last 5 years

**highsea** · 13 Aug 10,, 18:14

Originally Posted by astralis

yeah-- pick better examples next time. if core CPI goes up significantly, then we know there's an inflation problem.

And if it goes below zero for a quarter or two, we'll know there's deflation.

Originally Posted by astralis

by core CPI standards, that IS significant. take a look at the historical movement.

Still isn't deflation. It's just a decrease of inflation.

Originally Posted by astralis

which is ironically the same as your inflation fears. only given the trend lines, it does seem to be moving closer to deflation than inflation, don't you think?

Ask me that when we see some actual deflation.

Incidentally, I never claimed big inflation problems right now, so how ever many times you keep trying to make that claim I will continue to refute it.

Given the Fed's doubling of the money supply, now their monetizing of debt contrary to their prevous statements about shrinking their balance sheet, the need for the government to continue extensive borrowing over the next several years, if not more- I am pretty sure that I am not alone among those who think averaging some TIPS into the portfolio would be a prudent decision.

Don't matter to me whether you think it's wise or not. I can always count on you to repeat whatever the gov't talking point on any given issue happens to be.

It doesn't change my opinion that what is going on today is nothing less than the most spectacular failure of the keynesian state ever witnessed. How long it continues is anyone's guess.

**astralis** · 13 Aug 10,, 20:57

highsea,

And if it goes below zero for a quarter or two, we'll know there's deflation.

well, yes. but again, trendlines aren't going towards inflation. thus 1.) don't see why we should acquire TIPS any time soon, 2.) why even bring up volatile examples such as gold and fuel oil?

Incidentally, I never claimed big inflation problems right now, so how ever many times you keep trying to make that claim I will continue to refute it.

good, then you should have no problem agreeing with me that deflationary pressures (if not outright deflation) are the main problem RIGHT NOW, while inflationary pressure will be a medium-long term problem. i find your focus on inflation now to be somewhat akin to the unfortunate man finding out that he has slow-growing prostate cancer and ebola...and deciding to worry about the prostate cancer first.

Don't matter to me whether you think it's wise or not. I can always count on you to repeat whatever the gov't talking point on any given issue happens to be.

well, considering i didn't even VOTE for the current gov't, and that i disagree with them over such things as the execution of the afghanistan war, the stimulus (too little and weighted wrong), long-term budget timidity, the raising of the capital gains tax rate, and NASA, among other things, you're free to think that...but you'd be wrong.

It doesn't change my opinion that what is going on today is nothing less than the most spectacular failure of the keynesian state ever witnessed. How long it continues is anyone's guess.

compared to how following the prescriptions of neoclassical economics (which your economic views seem to track most closely to) failed during the Great Depression...the failure of Keynesian economics seems fairly mild in comparison. hell, most of the old-school Keynesians (and again, I'm -not- one) have screeched from day one how Obamanomics -wasn't- going to work because it was hardly Keynesian at all.