Markets could force Fed to empty the chamber

August 10, 2011

By Agnes T. Crane
The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Markets could force the Federal Reserve to use up the rest of its arsenal. Although investors found comfort in the central bank’s stated “range of policy tools” on Tuesday, by Wednesday morning they had a change of heart. The slide could press Fed Chairman Ben Bernanke to fire sooner rather than later to keep recession at bay. Trouble is, he’s packing a BB gun not a bazooka.

All of the Fed’s remaining options are controversial and none looks promising. But the Federal Open Market Committee’s decision to put a firm date — two years out — on its near-zero rates, over the objections of three members, indicates just how much the market turmoil has spooked policymakers already worried about the economy.

One possibility would be an updated version of “Operation Twist” from the 1960s. With it, the Fed could change the composition of its nearly $3 trillion balance sheet to favor longer-dated debt, in a bid to knock rates even lower.

There are two ways to do this. One, the Fed could reinvest proceeds from interest payments and maturing debt in longer-dated Treasuries. The other way would be to sell shorter-term bonds to buy, say, 10-year and 30-year bonds. But after the Fed’s bold action on Tuesday, the “Twist” looks too weak to accomplish much. Yields on 10-year Treasuries, after all, are already hovering around 2 percent.

The Fed also could opt to lower the measly 0.25 percent rate it pays banks to keep funds on deposit. Such a move, however, creates the potential for some nasty side effects, including endangering struggling money market funds.

And that leaves the printing presses. Theoretically, there’s no limit to the size of the Fed’s balance sheet. With every $200 billion of bond purchases equal to about a rate cut of 25 basis points, quantitative easing must still be high on the list for policymakers worried about recession and the possible deflationary pressures it would bring with it.

Inflation expectations aren’t signaling any worrying fall in prices on the horizon. They’ve been holding around 3 percent. That is higher than the 2.2 percent of a year ago, when Bernanke set the stage for QE2 in Jackson Hole, Wyoming, and might be enough to keep the Fed’s finger off the trigger. But Bernanke is headed back this month for his annual trip to the Wild West. If the market bloodshed persists, he may feel the need to fire off his peashooter when he’s there.

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Bernake has no choice. And deflation or no, more money will be printed which will have an inflationary effect on the economy. How much? That is the million dollar question or rather trillion dollar question. But you should have at least explained what deflation is for most people outside of Economists or those with Economics degrees won’t pick up the concept as easily as you threw it around.

You buy a house, money supply contracts, prices go down, the price of your home goes down but you still owe the same amount on the house so in real terms you now have to pay more for your house. That is deflation.

Okay, why not also discuss currency problems that has resulted and will continue to result in the dollars fall. Remember, when the people on fixed incomes realize that their SS check does not buy what it once used to buy, you will have unrest.

China as we speak is getting rid of its dollar reserves by the tens of millions, slowly of course, but they don’t trust the US dollar. And there you have a problem. If Chins does not trust the Fed, then you will have a crisis of confidence that could spread around the globe with countries dumping the dollars in favor of gold or the Swiss Franc.

My suggestion: Have the Fed print money specifically for banks to give 200k max loans to citizens. They will spend it, start businesses, and even pay off debt with it.
Make it at a decent rate of interest, and you may be able to create some demand. Banks will make money as people start paying the loans back, and be able to loan out more money. Inflation stays the same 4 percent tops, due to low unemployment. This may work, but at least it eliminates the middle man in all of this. May not work, but hey, its off the top of my head.

IF Bernake continues this course, you WILL see hyperinflation and it will occur sooner than you or I think. Deflation occurring during a depression? When was the last time you saw that? Hint: Bernake wrote a book about it.

So Bernake prints more money, the bankers continue to hoard the money, they do not collect on the toxic assets, but restrict credit, capacity is idled, and WHOLA, banks start falling like flies.
Bank of America will be the first, of the big ones to fall IMAO. I wonder if the government will take it over. Maybe it will. But this is what led to the Great Depression no?
History DOES repeat itself.

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