The Insidious Truth About Federal Reserve Policy

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 boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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