The Implications of The Federal Reserve’s Purchase of Treasuries: Inflation

THE FEDERAL RESERVE’S PURCHASE OF U.S. TREASURIES
WHAT DOES IT MEAN?

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What Was Done?

Update (3/23/2009): Today The U.S. Treasury unveiled plans to buy $1 Trillion of toxic mortgages and other distressed assets mainly from banks, in a public-private partnership.

On Thursday (March 18 2009) U.S. central bankers decided to buy as much as $100 Billion in direct debt, and up to $500 Billion mortgage-backed securities, from government-sponsored enterprises of Fannie Mae, Freddie Mac, and Ginnie Mae. Under the Term Asset-Backed Securities Loan Facility (TALF), the Fed will lend up to $200 Billion to holders of AAA rated asset-backed securities (ABS) collateralize by loans ranging from education, auto, and credit-cards, and loans guaranteed by the Small Business Administration. The total for TALF is reportedly up to $1.25 Trillion (originally $2 Billion, announced in November 2008). The government said that TALF will provide its first loans later this month (March 25 2009).

Federal Reserve policy makers have focused on what has been called “unconventional measures” or quantitative easing to increase the nation’s money supply and shock the economy out of recession. These measures are only considered unconventional because they aren’t needed or used in normal economic times, and only during much more serious economic downturns such as this one. This type of action refers to the deliberate creation of money by a country’s central bank to encourage spending. The Bank of England has committed spending up to £75 Billion on government bonds purchases. The Bank of Japan has also made similar moves. The Bank of Canada has been discussing both quantitative and credit easing measures in the upcoming months as well.

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Why Was It Done – Ease Credit to Fight Deflation

The Fed took such action because it fears deflation could persist, which results in a broad based decline in prices creating an environment which does not foster growth or price stability in the long term. Ben Bernanke said that the aim is to make an impact in lowering borrowing costs, by improving the functioning of private credit markets so that people can borrow again (for a variety of purchases) and help get the economy going.

Why is deflation considered so dangerous, that the government would try to avoid it at such a high cost? The government’s goal ideally is to have the economy grow (inflation) at a steady, stable, and manageable pace, while avoiding deflation and excessive inflation. In short, deflation is when the economy & country contract or shrink. When that happens it means companies are closing down or downsizing, resulting in lost jobs and lower wages. As a result demand drops, and prices in turn begin to decline, such as houses and a variety goods. Not all prices will decline, with the most likely being non-discretionary items (food, energy, etc). However, its possible to experience temporary short term price declines in such items as well.

To relate this to most people, imagine that your house now is worth significantly lower than the mortgage you took out to purchase the home. Combine that situation with a job loss or wage decrease. Now you would owe much more, and your loans become much more difficult to pay off. More people & corporations default on their loans, which result in further losses for banks and tightening of credit. The world (which have forgotten) has now been reminded of the effects of credit tightening on the economy. Widespread government assistance (public and corporate assistance) becomes an increasing problem, and strains the system more. With such strain ballooning, the government is forced to spend even more money (which they wouldn’t have). These chain of events send the country further into debt, as well as eventually devaluing the currency even more.

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Implications Of What Was Done

Although such a move has some desirable results in the short term (attempting to resuscitate the economy and avoid deflation), in the long term there are also undesirable consequences. The main consequence is high inflation (in the general sense, and not the nation’s official inflation rate as calculated by the central banks / government using the Consumer Price Index) when the economy recovers and growth resumes. The risk is that the Fed won’t be able to unload the securities and debt it purchased quickly enough to contain inflation.

The Fed also doesn’t really have the money on hand to purchase all these securities and give out all these loans, and already significantly in debt with their recent bailouts. Essentially, the Federal Reserve is now using its powers to print money to buy these treasuries and securities. They are increasing the money supply significantly, further devaluating the currency, which is another contributor of high inflation.

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What If They Didn’t Do It?

Its important to understand that in times like this, governments are left with very little choices and the decision was warranted given the worsening economy. They decided on the lesser of evils. The Treasury and the Fed must have weighed these negative effects, and decided it was still something that had to be done. The consequences of not doing so, may be much worse for the economy & government. It would likely send the economy into an death spiral and prolonged economic slump much like the Great Depression. That would lead to many negative chain reaction possibilities (too many to discuss in this article) that would be even more difficult to resolve, and would eventually leave the government in a much more weakened state to do much about it as well.

However, these types of negative & less negative choice outcomes are the inevitable byproducts of the years financial recklessness which lead to these financial/economic crisis type situations. There is always a delay, but eventually the results catch up. With this move they have now solidified/committed themselves to the eventual consequence of high inflation over the more negative consequences of prolonged deflation. When high inflation occurs a few years down the road, they will also invoke new measures, policies, to try and contain such inflation to manageable levels. The effect of those future moves will eventually stabilize/contain inflation.

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Why It Will Happen

One major drawback of being able to increase the money supply without any real limits, is that it deteriorates & erodes the value of the currency. It causes prices of goods & services to increase. Energy, food, & metal prices will also rise resulting in high inflation & the debasement of fiat money. The US government is already saddled with significant amounts of debt from their war related activities and Bush’s stimulus package, even prior to president Obama’s current stimulus and future medicare plans. Printing money will not improve the government’s debt levels.

Many of the publicly outspoken economists believe that the risk of high inflation in the future is not great, if the Fed is very careful. However, even if the Fed is careful the economic result of such moves is almost unavoidable. There may be a few years in between, but eventually we reach it. It is one of those cause & effect scenarios, and can be thought of as a law of Economics. If you do A, down the road you eventually get B. The Fed is naive to think that they will be able to avoid it (completely) by using (what they will believe to be) new policies, rules, and measures, that they almost undoubtedly will champion as being different than those of the past.

The Fed and their predecessors always think their polices are different than those of the past, but really they are the same, and the same outcome always occur. Purchasing longer-dated U.S. government debt in addition to the regular purchases of short-term Treasury bills, has been done before. Operation Twist which ran from 1961 to 1965 was used to flatten the yield curve in order to counter the then recession and trade deficit. The 1970s that followed, experienced a period of high inflation. Even though the reasons are different, the overall the actions are the same. And the consequences of such actions will be a period of high inflation. The Fed can only attempt to limit its negative affects.

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When Will It Happen?

When economy grows again, corporations will also grow and invest again. People will have jobs and start spending. The government’s main sources of income, tax, can then begin to rise to cover for the years of massive spending & deficits. Interest rates will also be increased. Any sooner, and they could kill off the economy again. So high inflation is unlikely before the economy is at a recovered level.

The economy won’t really be in what the general population will perceive to be in a recovered state until a few years after the stimulus takes affect. I still stand by my original assessments, which are unfortunately less optimistic than I would like. However, what my assessment tells me, and what I want to see happen are always two separate things. Investors will do well to be aware and ensure they always keep those two separate.

Its difficult to predict with any precision when the changes in the economy will occur, but we can estimate to within +/- 1 or 2 years, which is enough for us to make preparations & plans to take advantage of such knowledge. That being said I believe the economy will start to feel the affects of the stimulus plans & policies at the end of this year (2009) at the earliest. The economy won’t really grow at significant levels until roughly 3 years after the first stimulus was issued (in 2008), as it takes time for these things to get going and confidence to build up. That would take us roughly to 2011. Rates may increase slightly but I don’t believe it will be considered extreme. To put this into perspective, today in Canada, we can currently get a 5 year fixed rate mortgage at around 3.90%. We can definitely expect such rates to increase back to 6-7% levels. Similar & corresponding increases can be expected on other loan rates. In the U.S. we will see similar increases first, as Canada always lags behind.

Only a few years after the economy starts growing (approximately 5 years after the first stimulus) will the economy be in a state where it might be really growing at a healthy rate again, in which case we should see inflation start to increase more significantly. Even though the official inflation rate (based on CPI) may not increase significantly, given all the events & government actions, there is a high probability that we would see 5 year fixed rate mortgages in Canada to be in the low double digits. Similarly, rates on various loans would increase by a corresponding amount. Taxes will also be significantly increased to cover government debt. When that happens the government will really try to keep interest rates from increasing further. The costs of borrowing and taxes that are not associated with purchases are not used in the CPI, but a rise in our borrowing rates and personal taxes are still considered inflation (just not part of the nation’s official inflation calculation). Although Canada has different policies, our economy is undeniably tied to what happens in the United States. Trade between the two countries is so tightly connected that we more or less feel the same effects at a broad based level. Also keep in mind that the inflation rate, (central bank) interest rate, and prime lending rates are all different things. The national inflation rate (based on CPI) is used by the central bank to determine interest rates, which are then used by retail banks and lending firms to determine their lending rates (mortgage & loans).

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What Else Will Happen

Due to the erosion & devaluation of the US currency we will see hard assets increase in value due to their supply being relatively fixed. Metals such as gold, and energy prices such as oil will rise.

Although gold is seen as a safe haven, it arguably isn’t particularly as useful or in high of a demand as other metals. However, the reason it is seen as the safe haven is because it is what the world has come to accept as the backup universal/global currency. It honestly could have been diamonds, silver, or anything else for that matter. But gold was recognized and accepted on an international level (whether they realized it or not), very early on in mankind’s civilization. To get this same type of acceptance and recognition around the globe for something in place of gold, would be very difficult as the world disagrees and does not see eye to eye on so many issues. One day when the world is more united, such a safe haven may no longer exist or become obsolete, but we are obviously many many decades away from that. So for now investors need to recognize and accept the world’s view of this metal. Although gold has experienced short term price declines, it is likely it will increase significantly in the years to come.

The world’s dependence on oil (in its various refined stages) and its by products, not only as a fuel but raw material for a wide range of products is unprecedented. Its used in transportation, machinery & tools (construction, mining, agriculture, industrial production, etc), plastics, asphalt, etc, The world is slow to adopt new technologies, due to the economics of adaptation on a large scale. New technology in general, is also inherently slow to be adopted. In developed countries, the current infrastructure is so firmly rooted that such a dramatic change away from oil (as a fuel) very difficult and expensive. The new technology products too costly for the average consumer to afford. In emerging economies, oil based fuel and energy is the only economically viable alternative. Widespread acceptance will be even slower in those markets.Oil has also been increasingly expensive to extract, produce & refine (energy, financing, mine setup, exploration, & labour costs). Conventional and cheap oil is running out, and the more expensive oil sands and other areas are now the focus of attention. Oil has experienced a short term decline of significant levels ($40-$50 level), but unfortunately I still stand by my assertions that such price levels will not last. Again, its one of those things I don’t want to hear, but unfortunately my assessment points to such a conclusion.

With high inflation, mortgage and interest rates on loans/credit will become significantly higher as discussed. Even though wages and interest rates on investments will also rise significantly, they tend not to be enough to compensate for the higher borrowing costs, taxes, & price increases. Again, investors and average consumers should be aware of what is to come and plan for it. It is not unlikely that we will see inflation like in the 1970s again, and mortgage/lending rates hitting low double digits. Although inflation was high, it was not the end of the world. In the 1970s people were able to buy more than they were able to at any other previous point in time, as the economy was working & growing. It is likely that the economy will also grow & work when we experience high inflation in the years to come. We must plan to limit its negative impacts, but also take advantage of its effect on the economy.

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I encourage my readers to read or re-read a few specific articles that I had written. I’ve also discussed similar issues related to the economy & recession in my January 2009 article Investment & Economic Outlook 2009.

In my July 2008 article How The Financial Crisis Will Affect The US Dollar, Inflation, Gold, and Oil Prices I discuss money supply and inflation, in relation to its affects on items such as gold and oil.

In my January 2009 article, I wrote about the economics behind the historical Post-WWI Recession, and the similarities now

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An understanding of Economics, and knowledge of economic history, is a very necessary block of knowledge that an investor must have. There are many sources of such knowledge on the internet, and also in books. I prefer books as a resource for this particular topic as they are organized in a more efficient manner and contain more in-depth information.

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Thanks & Happy Investing!
The Investment Blogger © 2009

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3 thoughts on “The Implications of The Federal Reserve’s Purchase of Treasuries: Inflation

  1. Hi,

    Could you talk more about the treasury, interest rates, and most of all the correlation with it amongst mortgage/prime rates.

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