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What is the Fed Really Buying?

Posted by Larry Doyle on November 8, 2010 7:41 AM |

Quantitative easing is merely another tool to adjust monetary policy, correct? Perhaps. The question begs, then, after an initial round of a trillion-plus quantitative easing failed to stimulate the economy why should we expect any differently this time. Great question. Let’s navigate.

Quantitative easing involves the purchase of Treasury and mortgage securities by the Federal Reserve in an attempt to inject liquidity into the system, prop asset prices, and spur consumer demand. Or so they say. Well how is the overall level of credit in our economy trending?

The downward slope in the graph is an indication of both lessened credit availability and also lessened credit demand. The quantitative easing should directly address this reality, correct? I am not so sure about the “directly” aspect of that statement. In fact, I will go a step further and say I think the Fed is being less than forthright with the nation. If the Fed truly wanted to inject liquidity and capital into our economy and allow it to flow through to small businesses directly there are much better ways of doing it than by purchasing overvalued Treasury and mortgage securities.

Then what is the Fed truly doing with this quantitative easing program? My instincts tell me that the Fed may actually be undergoing nothing short of another backdoor bailout of our banking system. Really? Why would I write that? Well, Bernanke is catching a lot of heat both domestically and globally for impementing this program. In an attempt to defend himself and the Fed he spoke at a conference this past Saturday. The New York Times covered the conference and reported, Bernanke Attempts to Soothe Doubters,

“We’re not in the business of trying to create inflation,” he said at a conference here, speaking on a panel with his predecessor, Alan Greenspan. “Our purpose is to provide some additional stimulus to help the economy recover and to avoid, potentially, additional disinflation.”

Not everyone at the conference, organized by the Federal Reserve Bank of Atlanta and Rutgers University, agreed.

E. Gerald Corrigan, a former president of the New York Fed who also spoke on the panel with Mr. Bernanke and Mr. Greenspan, said he felt “uneasiness” about the latest decision.

“Inflation is, by its nature, a cumulative and self-reinforcing process,” Mr. Corrigan, now at Goldman Sachs, wrote in a paper accompanying his remarks. “Thus there is a risk, however small, that once that nudge takes hold, it may not be easy to cap inflation and inflationary expectations at levels that are still broadly compatible with price stability.”

Mr. Bernanke said he was “very sympathetic” to that concern, which tends to be held by Fed veterans whose formative experience was the Fed’s painful but successful battle against inflation from 1979 to 1982. But he also revealed a certain frustration at the sharp response to the Fed’s decision to renew a strategy, known as quantitative easing, that involves buying Treasury securities to lower long-term interest rates.

The strategy is unconventional, but the Fed’s usual tool to stimulate the economy, lowering short-term rates, is no longer available because the Fed already lowered those rates to nearly zero in December 2008.

“There’s a sense out there that, quote, quantitative easing, or asset purchases, is some completely foreign, new, strange kind of thing, we have no idea what the hell is going to happen, and it’s an unanticipated and unpredictable policy,” Mr. Bernanke said. “Quite the contrary: this is just monetary policy. Monetary policy involves the swapping of assets — essentially, the acquisition of Treasuries and swapping those for other kinds of assets.”

What? I did a double take upon reading that last line. What exactly is the Fed really buying via this quantitative easing program? Is the Fed merely cleaning the decks, that is the books, of our largest banking institutions in the hope that the banks can once again begin to lend? But who then gets stuck with the dregs that were on the banks’ books? “Oh no, LD, you don’t mean the American taxpayer is getting screwed again?”

Bernanke may be well intended but how about we open the Fed’s books and find out what is really going on.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. As President of Greenwich Investment Management, an SEC regulated privately held registered investment adviser, I am merely a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.

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