Busch: Fed Decides Then Justifies

Yesterday, the Federal Open Market Committee announced a new program of easing that entails buying US Treasury debt. The FOMC stated that, “…the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.”

The New York Federal Reserve detailed the purchases as the US central will buy maturities across the yield curve, but focusing most of their buying between 2.5 to7 years. What was surprising was that the Fed will buy up to $42 billion of longer dated US Treasury debt ranging from 10 to 30 years.

Today, US Federal Reserve chairman Ben Bernanke wrote an op-ed piece for the Washington Post defending this decision. “….low and falling inflation indicate that the economy has considerable spare capacity, implying that there is scope for monetary policy to support further gains in employment without risking economic overheating. The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed.”

Ben Bernanke, Federal Reserve Chairman
Ben Bernanke, Federal Reserve Chairman

However, he doesn’t stop there and lays out how this type of easing has helped in the past and indicates this is what the Fed is hoping for today.

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

This entire sequence raises many questions over the direction of current and future momentary policy. First, the Fed must be ignoring current food and energy inflation that is quite real for most Americans. Food prices jumped 1.4% in September and oil is up 21% since the end of August. Import prices are expected to rise 1.1% in October due to the rapidly depreciating US dollar. Also, Bernanke's op-ed appears to indicate that the Fed is now targeting stock prices and to push them higher. Would this mean that the Fed will target them if they appear overheated or target them when the Fed begins to tighten?

"This approach eased financial conditions in the past and, so far, looks to be effective again." -Chairman, Federal Reserve, Ben Bernanke

Next, the Fed appears to be engaging in activities that normally are performed by the US Treasury. By flooding the markets with US dollars, the Fed is effectively and actively engaging in a currency devaluation program. Since late August, the US dollar index has lost 9%. This has not gone unnoticed by countries like Brazil who have stated publicly that the US is engaging in a “currency war.” Also, the FOMC is buying debt and paying for it by placing a claim against the US government. Normally, the US Treasury authorized by Congress is the sole group with the legal mandate to do so. New members to the US Congress and Senate may not agree with this course of action without their explicit approval.

Finally, the central bank is artificially suppressing borrowing costs for the US government and thereby alleviating the market discipline normally imposed on profligate fiscal spenders like Greece and Ireland. Remember, ratings agencies downgrade sovereign debt when servicing costs breach 10% of tax receipts. This sets up a scenario in the future for when the FOMC needs to tighten monetary policy and needs to unwind their balance sheet by selling assets. Could they do it when interest rates are rapidly moving higher and it would speed a debt downgrade?

The list of potential policy pitfalls continues the further the Federal Reserve pursues a goal of increasing liquidity for a system that is not using the currently liquidity in it for lending. While this is great for stock investors now, this can't end well in the future if the Fed raises the level of inflation further. There are simply too many mistakes that can be made.

Andrew B. BuschDirector, Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him hereand you can follow him on Twitter at http://twitter.com/abusch.