How Fed's next trick will hurt bonds

The Fed's new plan to stimulate the economy would resume the rapid growth of the Fed's balance sheet and push it to $3 trillion sometime in 2013. The Fed's Operation Twist is scheduled to expire sometime this month but many are expecting the Fed to replace that with a more aggressive program of quantitative easing.

By Jim Jubak
12/10/2012 7:15 PM ET
MSN Money

I think the Federal Reserve is setting up investors for a significant change in policy to be announced after Wednesday's meeting of the Fed's Open Market Committee.

The new plan would resume the rapid growth of the Fed's balance sheet and push it to $3 trillion sometime in 2013.

And that would make the big problem facing the Federal Reserve and the U.S. economy even bigger. After expanding its balance sheet by buying what will soon be an additional $2 trillion in debt to help stave off the worst effects of the global financial crisis and then to support a stumbling U.S. economy, how does the Fed shrink its balance sheet back to something like normal size without crashing the U.S. and global economies?

The Federal Reserve's Operation Twist is scheduled to expire this month. That program to swap about $270 billion in short-term Treasurys for longer-term, five- to seven- year debt in order to lower long-term interest rates – to support the recovery of the housing sector and to stimulate economic growth -- is almost certain to end with the year.

But Fed Chairman Ben Bernanke and company are also almost certain to replace Operation Twist with a new, more aggressive program of quantitative easing. The fallout from this will be new pressure on bonds that could eventually send investors fleeing -- and those who aren't careful will get hurt in the rush.

A new buying binge

The Fed is clearly worried that the debate alone over the fiscal cliff -- or worse, the actual expiration of all of the Bush tax cuts, the Social Security tax reduction and extended unemployment benefits, plus the automatic budget cuts imposed by the debt-ceiling deal -- could slow the economy and even send the U.S. back into recession.

Recent speeches by Federal Reserve governors and basic math all suggest the new program will be an out-and-out plan to buy five- to seven-year Treasurys. That would continue the thrust of Operation Twist but get around a big problem the Fed now faces: It has become increasingly difficult for the Federal Reserve to sell its short-term holdings of Treasurys and to buy medium-term debt to replace them because the Fed has effectively sold most of its short-term holdings.

The new program would require the further expansion of the Federal Reserve's already massive balance sheet, which stood at $2.85 trillion as of Nov. 21. That $2.85 trillion level has been relatively stable since June 2011.

The new plan would change that. The number floating around Washington and Wall Street mentions Fed buying of about $45 billion in Treasurys a month. That would easily push the Fed's balance sheet to more than $3 trillion sometime in 2013.

Amazingly enough, the Fed's balance sheet was at just about $1 trillion before the start of the current downturn.

The Federal Reserve's most recent plan for shrinking its balance sheet goes back to 2011. Then, the Fed projected that it might start selling off some of its holdings of Treasurys and other debt in mid-2015. That, if you remember, is also when the Fed might begin raising the short-term interest rates that it directly controls. Recent announcements from the Federal Reserve's Open Market Committee have promised that the Fed would keep short-term rates at their current 0% to 0.25% level until at least the middle of 2015.

Logically, this plan made some sense: If the economy was strong enough by mid-2015 to withstand the downward pressure of higher short-term rates, it should also be strong enough to face some selling by the Federal Reserve of its medium-term debt portfolio.

The science of printing money

Why does all this matter? It all goes back to the why and how of the Federal Reserve's manipulation of its balance sheet to begin with. By buying Treasurys or other debt in the open market, the Federal Reserve stimulates the economy by adding to the money supply and lowering the cost of money (by lowering interest rates). At least, that's the theory behind the Fed's programs as the economy struggles to pick up speed after the Great Recession.

The Federal Reserve pays for these purchases, essentially, by creating money with the government's printing presses. That's why its purchases of bonds in the open market add to the money supply -- those purchases are paid for with newly printed money. Seen from this perspective, the Fed's balance sheet consists of "assets," such as Treasury bonds, purchased with money conjured out of thin air.

The big problem comes when the economy starts to pick up speed. Then, all that created money that was intended to speed up growth becomes the source of inflation and threatens to push up not just prices (consumer inflation) but also the prices of financial assets (asset-price inflation). Neither is good. The Federal Reserve has a clear mandate to fight consumer-price inflation because rising prices eat away at the value of money, making the fixed returns on things like bonds less and less valuable and reducing the value of paychecks, too. Once the expectations of future inflation become ingrained, the rate of inflation can soar as everyone tries to raise prices or increase wages faster than the rate of inflation.

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