Author: Colin Twiggs

Vince Foster at The Fiscal Times writes about this Wednesday’s FOMC meeting:

With Operation Twist due to expire at the end of the year and because the Fed is essentially out of short-term bonds with which to finance purchases, it is virtually assured that they will opt for outright purchases financed with printed money……….Now, said Ned Davis Research in a report last week, the Fed is likely to replace Operation Twist with purchases of Treasuries, perhaps in the $45 billion a month range, bringing its total monthly purchases to $85 billion.

Outright purchases of long-term Treasuries are far more expansionary than Operation Twist purchases which are off-set by the sale of shorter-term maturities.

Foster discusses Fed motives, considering that previous QE failed to lower interest rates or lift stock market values.

It has been my contention that the main objective is not to reflate asset prices but rather to stimulate credit creation and the velocity of money. According the Fed’s H.8 Release banks are holding over $2.6 trillion in cash that’s sitting idle on their balance sheet in securities portfolios. Bernanke is trying to flush the banking system out of these bloated securities positions and into extending credit by lowering bond yields to levels where banks can no longer afford to hold them.

Foster points out that negative real interest rates may be discouraging banks from lending, inhibiting the recovery. Also that bank balance sheets — bloated with Treasuries and MBS ($2.6 trillion) purchased as an alternative to lending — are vulnerable to capital losses should interest rates rise.

The Fed’s low-interest-rate policies have created a powder keg while being largely ineffectual in stimulating credit creation and consumption. The safest approach would be to reverse these policies and raise interest rates. Raising long-term rates to sustainable levels would reduce uncertainty and help restore confidence. House prices and stocks may initially fall but this would flush any excess inventory out of the system, giving purchasers and banks confidence that the market really has bottomed. With higher rates and stable collateral, banks will be more willing to lend.

At present we are all sheltering under the shadow of the Fed’s low-interest-rate umbrella, but with a nagging fear as to what will happen when the Fed takes the umbrella away. Fed policies are no longer adding confidence but increasing uncertainty. The sooner the umbrella is removed, the sooner the system will return to normality.

QE is likely to continue — Treasury needs to print money in order to fund the fiscal deficit — but this can still occur at higher rates. The fiscal deficit unfortunately will remain with us for some time — until confidence is completely restored and deflationary effects of private sector deleveraging are consigned to the history books.

Read more at How the Fed Will Affect Economy, Market in 2013 | The Fiscal Times.