The Insidious Truth About Federal Reserve Policy

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So far, U.S. Federal Reserve policy has done nothing to help the economy. To the contrary, it's actually been quite destructive.

Yet Federal Reserve Chairman Ben S. Bernanke and his cohorts will likely expand upon their ineffective policies next week by announcing a new "Operation Twist."

That begs the question: Why?

If ultra-low rates and quantitative easing haven't put a dent in unemployment or spurred economic growth, then why expand on those programs?

The answer: Because the Fed doesn't work for the American public – it works for Wall Street .

That's right. It's not the economy the Fed has on life support – it's the banks.

America's banks are facing huge litigation costs. Worse, they've grown entirely dependent on the Fed's easy-money policy.

So the Fed is going to bail them out – again.

And we're going to be the ones who pay for it.

Federal Reserve Policy Follies

To really understand what's at play here, let's start by taking a closer look at the Fed's misguided policies.

There are two reasons why Federal Reserve policy hasn't worked: First, the Fed's artificially low interest rates are handicapping the economy. And second, Bernanke is telegraphing Fed policy decisions to the markets, giving speculators an edge over investors.

By keeping overnight lending rates between 0.00% and 0.25%, banks can borrow at next to nothing and buy risk-free U.S. T reasury securities that yield a lot more than their financing costs. The result is a "positive interest rate spread," which is the basis for banks' revenues and profits.

Additionally, banks can borrow more money by using their Treasury securities as collateral for overnight and "term" loans. Then they use the cash they borrow to buy more Treasuries. They do this over and over again to leverage themselves.

Essentially, banks have become giant hedge funds that finance their "trading books" with virtually free money, courtesy of the Fed's zero-interest-rate policy.

Furthermore, the Fed is exacerbating this problem by telegraphing its moves. This happened most recently when the Fed announced its intentions to keep interest rates low for the next two years. And it may happen again after next week's Federal Open Market Committee (FOMC) meeting.

With the Fed telegraphing its moves to the world, savvy market players know they can borrow cheaply to leverage up their trading books until the Fed hints that it is changing direction. It's the ultimate trader's backstop.

Roger Ferguson, former vice-chairman of the Federal Reserve and now CEO of $453 billion retirement services giant TIAA-CREFF, told Fortune magazine that the Fed's policy "encourages people and institutional investors looking for a return to think about asset classes beyond fixed income."

In other words, it makes them reach for yield by chasing riskier assets.

That's not comforting to retirees living on fixed income, or to all the pension funds that rely on fixed income returns to meet their obligations. But it is comforting to the hedge funds that are increasingly getting retirement fund allocations to take bigger risks to offset lower fixed portfolio returns.

The Fed's Next Disastrous Decision

So what's Bernanke telegraphing now?

Well, with the U.S. economy close to a double-dip recession, the Fed is set to announce its next move after the Sept. 20-21 FOMC meeting. That move is likely to be a twist on quantitative easing to lower longer-term interest rates. This new policy tool is being dubbed "Operation Twist," or "Operation Twist 2," since it's actually a reprise of what the Fed did in 1961.

The twist would involve selling or replacing maturing short -term notes and using the proceeds to buy longer-term notes and bonds. The goal is to flatten out the yield curve or "twist" it so borrowing for longer periods of time becomes cheaper.

Operation twist is supposed to lower rates to stimulate demand. But what the Fed doesn't seem to understand is that interest rates have been very low for a very long time and domestic demand hasn't increased at all.

So, if keeping rates artificially low hasn't worked, why is the Fed so aggressive in pursuing this policy?

Well, it's easy to point to high unemployment and say business and hiring won't pick up until confidence returns, but the real reason is more insidious.

It's about the banks.

A Secret Agent

The Fed is an agent of the banks and, as such, it continues to come up with new ways for them to make money, risk free.

As I said earlier, many of Wall Street's biggest players are facing huge litigation costs. But that's not all. The bigger problem is that they've grown entirely dependent on the Fed's easy-money policy. And now artificially low rates are going to come back and hurt banks.

If banks lend out long-term at low fixed rates and their short-term borrowing costs start to rise (which they will eventually), they will end up losing margin on loans. They also will take losses if short-term rates start rising faster than longer-term rates, which is what operation twist might accomplish.

That's why banks aren't anxious to lend to consumers or small businesses right now. And if we get Operation Twist 2 and longer-term rates come down, do you think banks are going to be more or less inclined to lend at lower rates for longer periods of time?

Essentially, the Fed is playing with fire. Artificially low rates are distorting free markets, true risk measures, and the economy. And by telegraphing its moves, the Fed is creating volatility that clouds long-term investment horizons.

If the Fed didn't telegraph its moves, volatility would be short-lived since m arket participants would make rapid adjustments to Federal Reserve policy decisions reflected in their open market trading operations – not their articulated policy pronouncements .

And that makes me wonder: Has volatility been engineered into the economy and capital markets to the benefit of Wall Street?

Maybe it's just "unintended consequences" of failed policies. Then again, maybe it is the tail wagging the dog. Either way, if you want to play the markets, use the Fed as a backstop and leverage yourself against its misguided policy decisions.

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About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Short-Side Fortunes, Shah shows the "little guy" how to make massive size gains – sometimes in a single day – by flipping large asset classes like stocks, bonds, commodities, ETFs and more. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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  1. david tarbuck | September 15, 2011

    Ficticious capital but nevertheless profits with no risk (untill thr wholr economy buckles under its weight) ar taxpayers expense.

  2. Werner | September 15, 2011

    I didn't really need to be warned about the dangers of US financial policy. Nevertheless, your warning certainly comes on time for many over-confident US and other investors. USA is broke, Europe by and large as well, with a very few small exceptions.
    Living in Switzerland I am glad to stay with my currency, even if our central bank has taken some very disputable steps, steps in fact induced by EU and USA financial disorder, though the 2 big Swiss Banks aren't much behind in the race to nonsense. Meanwhile it is the man in the street who has to come up for the damage either by losing income or money!
    Sad world indeed.
    Thanks for your alerts!

  3. rich | September 15, 2011

    Excellent article. We need Ron Paul for 2012.

  4. greg e | September 15, 2011

    I do not pretend to be an expert in banking matters, but would this move put pressure on mortgage rates and possibly reduce them? I'm trying to be a little less cynacle and saying that just maybe they are also trying to influence the housing market – though your points are well taken! Bottom line is that if the Fed had a single mandate of supporting a strong currency, none of us would be reading – or writing for that matter – about any of this!

  5. Petr | September 15, 2011

    Here in Czech Republic, fortunatelly, we still have our curency and not EUR or USD.
    It is a czech crown.
    When I was studing in USA in 1999, I could buy a dollar for almost 40 crowns,
    today I need just 17 crowns. Well, the difference is that our national bank can not pr
    int money that easily….

  6. bob paglee | September 15, 2011

    The Fed is aiming to lock up those currently fairly low yields on long bonds before they begin to skyrocket due to the coming inflation that the Fed's continued money-printing will eventually produce

  7. Jay Curtis, author of THE CODE | September 15, 2011

    The real question is exactly how will all this manipulation end and what happens when the house of cards come crashing down. FDR avoided a dictatorship in our nation after the depression put half the nation out of work. Germany did not fare so well. If people think that the average American, who is fed up with the corruption in Congress, corporate executives making hundred million bonuses, etc. — if you think Americans won't chuck the democracy we have (because it is so broken that it may be beyond repair) think again.

    The real question is when the end comes, how many politicians will be lined up against a wall and shot? Absurd is it? Think again and just remember Germany after World War I. The only answer is REFORM, REFORM, REFORM. Dump the seniority system in Congress. Change the constitution prohibiting corporate political contributions and fund political campaigns (modestly) with Federal and State money. Put term limits on all elected officials and pay NO salary for serving, just living expenses while in office. Raise taxes on billionaires and millionaires and cut tax subsidies to big oil, agriculture and anyone else our Congress has mistakenly provided a subsidy. Curb speculation on Wall Street in all things, commodities, futures, derivatives, stocks, packaging of mortgages by enacting regulations and margin requirements that have real teeth.

    Do this and we have a chance. Don't and we are doomed.

    Jay Curtis (author of THE CODE)

    • DENNIS MILLER | September 20, 2011

      Go one step further, pass a law that no one, no organization, no company, etc can contribute more than $1.00 to any political campaign. Level the playing field with the rich and corupt. Make it mandatory that all TV and radio and newspapers, magazines interview all the candidates or hold debates. We don't need to hear all their lies, just show us their past voting records. It shouldn't cost so much to run for office and special interests should not be deciding the outcomes with their wallets!

  8. Allen Novotny | September 15, 2011

    Shah, you give the impression that the Fed has a choice about keeping interest rates down. I don't think they do. What would happen if interest rates move up to, say, 7-8%? Look what the yearly interest be on our current debt. I think the Fed is caught between a rock and a hard place.

  9. topeka | September 15, 2011

    Thank you for the information: But for you, I would not be aware of Operation Twist 2.

    As for the comments about the Fed's subservience to the banks (among other nefarious priorities), glad to you are on the right page with my grandmother….

    :-)

  10. Lee Adler / The Wall Street Examiner | September 15, 2011

    I agree with Mr. Gilani about the Fed's disastrous policy blunders, one seemingly leading of necessity to the next. But I am scratching my head about the US banks. With the exception of a few weeks here and there, they've been consistently reducing their Treasury holdings. They seem to be either constrained from buying more, or they are simply unwilling to buy more. Instead, they piled up $1.6 trillion in cash reserves at the Fed, where it just sits, earning next to nothing. Meanwhile, the Primary Dealers were persistently net short Treasuries until about a month ago. They've gone net positive, but they are trimming their holdings of other debt securities. Now the stories are beginning to leak out about how a few of them lost money in their trading in the last quarter. That comes as no surprise considering their large short position, just as the recent Treasury market buying panic took root. It looks as though the PDs fed that with their short covering.

    This seems a bigger mess than even those who are well plugged in can comprehend. I think the Fed is clueless about what to do. The Fed has consistently seemed unable to understand the consequences of their policies, or if they understood the negative consequences, they didn't care because their only objective was to to what they saw as needed to save the banks. Operation Twist, which, based on the trial balloons in a variety of semi official Fed organs seems to be a done deal, will be nil in terms of boosting the market. I don't think the banks will bite, and I think that bond traders will sell the news once it is formalized.

    But as long as the chaos continues in Europe, all the cash that the ECB prints and pumps into their banks will flood out toward perceived safer havens. Perversely, the US gets the benefit of that.

    The world has gone mad.

  11. RW | September 15, 2011

    It would seem the Fed is doing this because it's about the only thing they have left to try to stimulate the economy. The one effective solution – another stimulus package – is impossible because of republican intransigence in Congress. This would stimulate demand and kick-start the economy. The same thing will probably happen to Obama's jobs bill. The Republicans have also made it impossible for Congress to re-regulate the banks and Wall Street, so yes, they will go and leverage themselves to oblivion once again, given the money to do it. If you will notice, the fact that people sold stocks and bought US Treasuries – even at lower rates – indicates the US isn't broke and can still borrow money. But this opportunity should be used to get the economy going, stimulate demand and GDP (which would increase tax revenue), and make a long-term plan to reduce the nat'l debt to reasonable levels. But this is all unlikely because the GOP would rather trash Obama than help the American people.

  12. don day | September 15, 2011

    thanks

  13. Vinay | September 15, 2011

    Sha, you have said many times that the banks can borrow cheap from the Fed on an overnight basis and invest in Treasuries at a positive spread. This may be true in theory but really needs hard evidence as to THE EXTENT to which such borrowing is permissible. Regardless, the ultimate answer is to destroy the Fed because it is an institution based on an absurdly illogical Keynesian fantasy.

  14. Jesse Ledbetter | September 15, 2011

    We who retired with great hopes of seeing IRA's grow in leaps and bounds, instead stood and watched helplessly as the Market disolved our savings. GE and Franklin Templeton took care of mine. I kept being told to hang on that the turn around was just around the corner. Unfotunately, no turn around and loses so deep even with a rebound, I would not be around to see the recovery. I took what little was left, after paying the 6 o/o early withdrawal penalty and put it into a home I hoped to sell at a profit. You know the rest of the story, the bottom fell out of the housing market. This could, in my opinon, been averted in the Fed reacting with a higher interest rate

  15. Mukesh | September 16, 2011

    After two consecutive Quantitative Easing, Federal Reserve found that economy is not responding the way they had expected. Therefore, they deferred third Quantitative Easing, which is only helping to push inflation. Federal has not change Interest rate since Nov 2008. What i feel now that this issue could not be tackle without Government's some extensive measures.

  16. PT | October 14, 2011

    I honestly believe that trying to control an economy by altering the supply of money is like trying to control a garden by altering the supply of water.

    Want more plants? Turn on the water. Want less plants? Turn off the water … and you end up with the most efficient plants in the world … WEEDS! Too bad there are no roses … but that isn't efficient, is it?

    Isn't that exactly what is happening? Turn up the money, turn down the money … efficient markets …

    Perhaps it takes a little more effort than that to produce a good economy, just like it takes more than that to produce a good garden.

  17. Robert Stone | January 27, 2012

    The legislation that was passed on Dec 23 1913 when most of congress was on vacation and only stooges of international banksters were told to stay so they could get enough votes to pass the infamous federal reserve act.. which was the tool the international bankers used to get control of the money supply just as they always have tried to do .
    Andrew Jackson was the only president to beat them and the attempted assassination failed. It didn't fail on Mckinley, Lincoln and JFK, and possibly Garfield.

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