The Fed Throws A Spit Ball

As the American Lost Decade(s) unfold, the Federal Reserve’s options to influence economic output dwindle. Today, the Fed confirmed the economic horizon will remain bleak. It also announced it would sell $400 billion of its near dated Treasuries and buy longer maturity ones. In a nut shell, Bernanke is trying to keep today’s free money and ‘bend’ the long term interest rates lower. The move (like earlier QE2) will have little impact in real economic output. The markets understandably aren’t impressed and fell on the grim forecast:

The Fed will replace some shorter-term debt in its portfolio with longer-term Treasuries in an effort to further reduce borrowing costs and keep the economy from relapsing into a recession, confirming market speculation that policy makers were planning an “Operation Twist” similar to a program in 1961.

“Markets took note of the Fed’s downward revision of the economic outlook and upgrading of downside financial risks,” Mohamed A. El-Erian, chief executive officer at Pacific Investment Management Co. in Newport Beach, California, wrote in an e-mail. Pimco is the world’s largest bond-fund manager. “While Fed purchases can influence Treasury and mortgage valuations, it is limited in its ability to deliver economic outcomesz” . . .

The Fed also said today it will reinvest maturing housing debt into mortgage-backed securities instead of Treasuries. “The mortgage story is the most important part,” said William Larkin, a fixed-income money manager who helps oversee $500 million at Cabot Money Management Inc. in Salem, Massachusetts. “This goes right to the source. This will create a wave of refinancings on the mortgage side.”

In short, the Fed’s move will not impact the real economy but might have some impact on artificial economic activity like re-financing, although that market segment is not infinitely elastic — i.e., many have already re-financed and now weigh the costs (aggravation as well as real) versus marginal benefit. Naked Capitalism also notes the flattening long term rate will undercut the basic business model of the banking system as a whole.


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