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Just when we think
that Bernanke has exhausted his ability to come up with harebrained schemes
to distort prices, he proves us wrong. Last week it was reported that the Fed
was considering a new way of putting downward pressure on long-term interest
rates. Why? Because as everyone knows, the US economy would be doing much
better if interest rates weren't so darn high.
The new
tactic would be a variation on the old tactic that goes by the name
"operation twist". Under the old tactic, which the Fed began to
implement during the second half of last year, the Fed sells short-dated debt
securities from its stash and uses the proceeds to buy long-dated debt
securities. This would tend to contract the yield-spread (flatten the yield
curve) by pushing long-term interest rates downward and short-term interest
rates upward, except that at the same time the Fed does whatever it needs to
do to keep the official short-term interest rate near zero. The idea, then,
is that the yield-spread contracts due to falling long-term interest rates.
The problem
with the old tactic is that it is limited by the Fed's holdings of
short-dated securities, which isn't good. After all, if the Fed and the
government wanted limitations they would have stayed with the Gold Standard.
One of the main purposes of the monetary system's current design is that
there be no financial limitations on the extent to which intervention can
occur. The new tactic under discussion would solve this problem.
Under the new
tactic the Fed would have the ability to buy an UNLIMITED amount of
long-dated debt securities using money created out of nothing. It would also
have the ability -- so the story goes -- to eliminate the inflationary
effects of this monetisation by issuing new
short-dated debt securities. Putting it simply, the Fed would create new
money to buy long-term bonds and then 'soak up' this new money by selling
short-term bonds. The result is that long-term interest rates would be forced
lower, provided that short-term rates continued to be pegged near zero. And the
best part: there would be no inflationary effect! Or would there?
The reality
is that there would be at least three inflationary effects.
One is due to
money being injected into the economy at one point and withdrawn at a different
point. This means that even if the Fed 'soaked up' the extra money as
promised, the act of injecting and removing the money would distort relative
prices.
A second
inflationary effect stems from the fact that the money 'soaked up' by the Fed
wouldn't disappear. It would, instead, be temporarily removed from the
economy in exchange for short-term interest-bearing securities. In effect,
the money would be parked in time deposits at the Fed. At some future time
the owners of these deposits would want their money, at which point the Fed's
original purchase of the long-dated securities would effectively become an
outright debt monetisation (QE).
A third
effect that also comes under the "inflationary" umbrella is that
the creation of these new short-term deposits at the Fed would alter the
private banking system's deposit structure. This is similar to the first
effect, in that it wouldn't bring about an economy-wide loss of money
purchasing power but it would distort relative prices. By way of explanation
consider the hypothetical situation of Bill, a wealthy investor who has $100M
invested on a short-term basis with an investment bank. Bill decides that
he'd rather invest his $100M in the new short-term securities issued by the
Fed, so he sells his existing investment. In this hypothetical example the
Fed's policy has resulted in money being transferred from the buyer of Bill's
investment to the Fed, and the transfer of money from the Fed to the seller
of the long-term bonds purchased by the Fed. Who knows what the seller of the
long-term bonds will do with the cash received from the Fed? The answer is
that nobody knows. Maybe he will buy oil futures, thus boosting the cost of
energy.
There are
undoubtedly other effects, but you get the picture. Like all attempts by the
central bank to manipulate money and interest rates, this new twist on
"operation twist" will cause problems in addition to the most basic
problem. The most basic problem is that the central bank shouldn't be making
any attempt to force interest rates below where they would otherwise be.
Bernanke is
like a kid with a new chemistry set who is gleefully mixing chemicals
together without the slightest clue as to what the reaction will be. The
difference is that whereas the kid with the chemistry set is probably going
to do no worse than burn a hole in his parents' carpet, Bernanke's monetary
experiments are burning holes in the US economy.
Steve Saville
www.speculative-investor.com
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