Wednesday, June 20, 2012

Bernanke Offers More Twisting

The big news in the financial markets earlier today was the FOMC meeting and the Ben Bernanke news conference.  There was no major news.  The Fed is predicting lower growth than originally expected.  The biggest news is the announcement that "Operation Twist" will continue.  I have written about Operation Twist before.

The stock market did not do much on the news.  Neither did much of anything else.  Oil went down and gold went down a little.  Overall, there was not much excitement either way.

The Fed is grasping at straws with this operation twist business.  As I wrote back in February, this policy is not without its consequences.  Lower long-term rates have not done much for the housing market and who knows what will happen to those rates once the Fed stops buying longer-term bonds.

One thing I suspect is that the Fed is buying longer-term bonds so that there will be less rolling over of debt in the near future.  If interest rates and price inflation both go up, then there will be less shorter-term debt to roll over, which means that interest rate payments will not increase as much for the U.S. government.

Of course, as I mentioned, these longer-term bonds would also decline in value if interest rates go up.  This means that the value of the Fed's holdings would go down.  It would mean that selling these assets does not deflate the money supply as much.  So if there were a scenario where price inflation was soaring, the Fed would have less ability to slow it down.

Aside from these points, operation twist does not mean much.  The Fed ended QE2 almost a year ago and the monetary base has been flat or even slightly down since that time.
http://research.stlouisfed.org/publications/usfd/page3.pdf

The Fed is in waiting mode right now.  It is trying to be Goldilocks.  Not too much inflation and not too much depression.  The problem is that the porridge is going to start being hot and cold at the same time.  It will be freezing on one side of the mouth and sizzling hot on the other.  In other words, we could end up like the 1970's where we have a recessionary environment with simultaneous price inflation.

When the time comes, I still believe the Fed will choose a depression over hyperinflation.  I'm not sure when that time will come, but the Fed is trying to hold it off for as long as possible.

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