Sterilizing The Federal Reserve

The straws are in the wind: Smart Money is betting now that the Federal Reserve, Uncle Ben Bernanke’s Magical Mystical Money Machine Extraordinaire, will be buying more of Uncle Sam’s $1.3 Trillion out-of-control deficits again this year.  June is Smart Money’s month of choice.  But don’t ‘take that to the bank’, because like all 800 pound gorillas The Fed moves when the mood moves it.

We’ve already had QE 1 and QE 2, so this would be the third time the printing presses will have been turned on to paper over the deadlocked cynicism of Congress and the leadership-deprived incompetence of the President.  My personal guess is that the size of the T-Bond purchase will be roughly the same percentage as it was before; 40-45% of the $1.3 Trillion, or about $520-585 Billion.  Fresh wallpaper!

There will be one difference this time, Smart Money thinks.  This time the purchase of Treasuries will be “sterilized”.  While it might be easier to just sterilize The Fed Chairman and shut this feckless propagation of money down permanently, that is not what the term means.  Take a look at this graphic that appeared in the WSJ. 

The sterilization process starts the same as a straight Treasury buy.  The Fed prints money and buys Bonds from either the open market or directly from Geithner’s Treasury.  That money is now used by the Treasury to pay bills and fund payments like Social Security, so it enters the nation’s monetary bloodstream quickly.  And like all payments it ends up in the bank accounts of millions of people, and in the hands of the banks.  QE 1 and QE 2 ended right there.  Treasury Bonds (QE 1) and mortgages (QE 2) in The Fed’s vault, money out in the economy.

Here’s where sterilization is different.  The Fed would “sterilize” if they wanted to take market pressure off Treasury auctions, thus keeping interest rates low by reducing supply, but did NOT want to flood the economy for a third time with more money.  The Fed would borrow from the banking system an amount roughly equal to the amount of the Treasury Bonds purchased.  So, $550 Billion in long dated T-Bonds (The Fed wants long term rates low) bought would be paid for with $550 Billion in new short term borrowing from the banks.  Money flowing into the economy through the Treasury is extracted by the Fed through the banks.  It’s a money wheel, and the amount of money in the system would be roughly the same as before. 

Now, if this strikes you as a little squirrely, rather like chasing your tail, at the very least a magician’s sleight of hand, get in line.  This is just another of the marvelous games you get to play when you’re a central banker … games that would get you 10-15 years in “federal housing” with Bernie Madoff as a roommate if you played them, or if IBM or Ford or Exxon did.

If you think about that graphic a bit more now, it’s clear that what will have happened, if it does happen of course, is that The Fed has substituted government money for private-market money as a source of funding 40% of this year’s deficit.  The Fed is doing this to manage (doesn’t that word “manage” sound professional?  Closer to the truth is the word I prefer: “manipulate”), to manipulate Treasury interest rates, sustaining them at lower levels than the private market would demand if left alone.

Boiling it down: The Fed can borrow at lower cost from the banks than the Treasury would be able to from private markets without Fed interference, so Ben is protecting the Treasury.  And Congress.  And the President.

Every one of these market interferences gives the Congress and President more time to do absolutely nothing and generally pours more gasoline on a world debt crisis already in flames.  The Fed Chairman thinks he will be able to douse the fire when the time comes.  I think when the time comes Ben’s going to find he has a water shortage…

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