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The All Powerful Federal Reserve: Part II

Posted by Larry Doyle on June 12, 2009 12:19 PM |

Is the All Powerful Federal Reserve omniscient, omnipotent, and omnipresent? Any institution that purports to be transparent but ultimately clouds itself in a shroud of “financial intrigue” deserves serious questioning. Congressional efforts on this front regularly fall woefully short. With a few exceptions, serious media analysis of the Fed is also deficient. Fortunately, the Wall Street Journal provides a reasonable overview of recent Fed maneuvers, Fed to Keep Lid on Bond Buys. Let’s navigate the inner workings of the Fed and play devil’s advocate in the process.

The WSJ highlights:

Fed officials have become more confident recently that they have stabilized the economy and set the stage for recovery. But divisions are brewing within the Fed over whether it should do more to speed the healing, pause, or start pulling back to avoid an outbreak of inflation.

Those crosscurrents are likely to inhibit bold new strokes by the Fed at its next meeting, in contrast to earlier in the year, when a bleak outlook spurred aggressive action.

At long last, a hint of sanity on the inflation front emanates from within the hallowed halls of the kingdom of the Federal Reserve.

Please recall that when the Fed announced its increased level of aggressive quantitative easing, the 10 yr Treasury rallied 50 basis points from a 3.1% to a 2.6% in one day. That sort of move is unprecedented. The 10yr, even with the Fed’s support, has since retraced 1.2% in the last three months. Where would the 10yr Treasury be without Fed support? 4%, 4.25%, 4.5%? Who could estimate for sure?

The fact is the Fed may have injected too much liquidity too fast into the system. What are the results of the “liquidity rush?” Markets which are disconnected with the underlying economic fundamentals. Fed officials seem to appreciate that they may have overplayed their hand. The WSJ offers color on this front:

Interest rates on everything from business loans to home mortgages tend to move in tandem with Treasury rates. If government-bond rates rise too much too fast, they could short-circuit a recovery by choking off consumer and business borrowing and spending.

Fed officials aren’t convinced that is happening yet, so they aren’t inclined to use their muscle to restrain bond yields any more than they have already set out to do. That could change if their views of markets and the economy change. Fed officials say much needs to be hashed out at the next meeting.

Do you get the feeling that these Fed officials are operating much like NASA controllers? Too much speed, and our “economic” airbus may very well overshoot the runway. Too much fuel and we may burn up prior to reentry. If that is the case, we may need to “dump” some fuel prior to reentry. How does the All Powerful Fed manage this delicate and technical task? Very carefully. To wit, the WSJ offers:

When officials convene on June 23 and 24 in Washington, one idea on the table will be to stretch out over a longer period of time planned purchases of Treasury securities or mortgage-backed securities. Doing so would avoid an abrupt, and perhaps disruptive, end to the buying and give the Fed time to assess the outlook. The Treasury has set out to buy $300 billion of Treasurys by the end of August. It is on a path to buy $1.25 trillion of mortgage-backed securities by the end of this year or early next year.

So far, the Fed has purchased $156.5 billion of government bonds. Officials could also change the mix of their purchases.

The Fed has utilized approximately half its “purchasing powder” and rates have backed up a staggering 1-1.25% in the process. Why? Inflationary fears. Do we run the risk of further fueling the engines of inflation by pumping even more money into the tank? I believe we do and fortunately some within the Fed are starting to appreciate the signals being sent by the market.

Some Fed officials worry that if they wait too long to reverse the tidal wave of money they’ve pumped into the financial system, that could spark inflation — a threat that bond markets might already be signaling by pushing up Treasury yields. “Just as there is slack, there is also an enormous amount of stimulus in the economy and coming into the economy,” said Kansas City Fed President Thomas Hoenig in an interview. “Being too slow to remove our expansionary actions would very likely be inflationary.”

Is the All Powerful Fed capable of properly pushing and pulling the economic levers at its disposal?

The Fed’s task is complicated by the fact that it is using tools it has never used before.

Here’s hoping this flight does not also include, “Houston, we’ve got a problem.”


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