The Fed’s Arsenal Is Lacking Its Most Important Tool

There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.  … the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.

Frederic Bastiat (1801-1850)

Vitaliy Katsenelson
Contrarian Edge
Business Insider

Over the next eight months the Federal Reserve will conduct QE2 – quantitative easing, the sequel. It will buy $600 billion worth of US long-term bonds in the open market, close to 7% of all Treasury securities in public hands, or about the amount the debt that the federal government will issue over that time period.

The Fed has already taken short-term rates down to zero, pushing income-seeking investors and savers to higher-yielding (lower-rated) and higher-duration (riskier) bonds. Now, with the magic of QE2, the Fed wants to drive long-term rates down to unseen levels and push all Treasury investors (short or long) towards higher-risk assets – junk bonds, real estate, stocks, and commodities.

The Fed also hopes (that is all it can do at this point) that low interest rates will nudge businesses to invest and to hire. That’s unlikely.  The value of any asset is the present value of its future cash flow.   As my favorite philosopher Yogi Berra (allegedly) said – “In theory there is no difference between theory and practice. In practice there is.”

In theory lower interest rates decrease the rate that businesses use to discount future cash flows – making future cash flows more valuable today – and the Fed is betting on that. In practice, however, the fickle source of lowered interest rates is not lost on businesses. Rising debt on government and Fed balance sheets and an overheated money printing press don’t generate confidence about future cash flows.  High government debt eventually leads to higher taxation, higher interest rates, and lower growth.  So the Fed’s action may have an impact opposite to what they intend.

At some point quantitative easing will be followed by quantitative un-easing, as the Fed will have to sell all those bonds back, unless they are held until long-term maturity.  Either way, it will bring higher interest rates.

Read the rest at Business Insider. Also at the site, Bernanke’s QE2 May Create 700,000 Jobs, But They’ll Be In Mexico, Peru, And China

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