RebelCapitalist: Financial Information for the Rest of Us

The Fed Unleashed

Mar 19, 2009 | By: Mr_Blue | Tags: u.s. treasuries, inflation, federal reserve, interest rates

The Federal Reserve announced yesterday that it was purchasing $300 billion in long-term U.S. Treasuries. A very bold move. Purchasing U.S. Treasuries in the open market is the Fed’s most powerful weapon against a recession. But it does have plenty of risk.

The Fed is doing two things with this big purchase: 1) increasing the money supply and 2) bringing long-term interest rates down - particular U.S. Treasury rates which in turn may bring down mortgage rates. The money supply is increased because the Fed is going into the bond market and purchasing U.S. Treasuries from investors who are selling. Obviously, the Fed is buying with U.S. dollars so sellers have a ton of newly printed greenbacks. The theory is more money for the economy to use kind of like “priming a pump”. In terms of interest rates, there is an inverse relationship between bond prices, such U.S. Treasuries, and bond yields (commonly referred to as “rates”). So, if bond prices go up bond yields go down. This huge purchase effects the laws of supply and demand - in this case the supply side. The Fed’s purchase of $300 billion means there are fewer U.S. Treasuries on the market which in effect drives up the price and drives down the bond yield.

The risk is relates to that old axiom that nothing is free. The Fed makes creates more money which decreases the value of the U.S. dollar on currency markets but it also has an inflationary effect, particularly on oil prices because now it will take more U.S. dollars to purchase a barrel of oil. In terms of U.S. Treasuries and interest rates, consider this simile: it is like when you hold a basketball under water and when you let go it shoots up with great force. That is the risk with interest rates - so the Fed just brought down long-term rates with its purchase but it risks not being able to control interest rates when they start going up and they will go up. This action runs the risk of inflation and I am not talking about mild or moderate inflation.