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The QE Dance: Should the Fed Walk Away to Reduce Rates?

Tue, Jun 9, 10:28 AM ET, by Kenneth C. Bateman

At some point, the Federal Reserve’s policy of Quantitative Easing (QE) will have to end. The decision for the Federal Reserve to provide this support has been much debated. There is a real question about what will happen when the Fed finally decides to stop giving this support to the Treasury.

Currently, The Fed’s QE policy is attempting to protect the Federal Government, via the US Treasury, from exposure to higher interest rates.  The implicit goal of QE is to provide enough time so the government can resolve the current economic crisis.  More succinctly, the Federal Reserve and the U.S. Treasury are working closely together to make sure that the government does not have to pay market determined interest rates for their funds.

Not feeling the restraint of market-based borrowing costs, the Federal Government has essentially signed itself up for a spending spree.  This gets to the heart of the basic economic problem: unlimited wants versus limited resources.  The government, being offered cover for their actions, has blatantly showed its desire for unlimited wants.  After all, what is the demand for something that is free?  There is unlimited, or at least theoretically, infinite demand.

Despite their best efforts, the current actions by the Federal Reserve have stoked an inflationary concern, which has driven up yields.  The entire thesis of the Federal Reserve action is to force interest rates lower to allow cheap federal stimulus and easy financing for business and consumers. The Fed has now entered a point where the inflationary concern is making their actions counterproductive.

If they want to lower interest rates the Fed should end the current QE policy, or at least signal the initiation of a QE wind down.

Once Fed QE support for lower rates ends, we can expect a large upward swing in Treasury yields. Here is why. Bond investors, whose sole purpose for purchasing the instruments was to have the Federal Reserve be the "greater fool," would immediately exit their positions.  However, most of the reasons for the so-called inflation trade—the so-called “printing money” and “monetizing the debt” strategy—will be eliminated.

Is it possible that yields will represent a significant value at that point?  Once the interest rate on new borrowings is reflective of market-based forces, plans for federal spending would likely be curtailed, as the government must be reacquainted with the concept of limited resources. The resulting lower levels of fiscal stimulus would be contractionary for the economy.

The result of ending QE, quite counter intuitively, is that yields could begin to fall as Treasuries look to be a better value going forward given the rather meager growth profile of the nation over the intermediate term.  Strangely, the Fed could get what it wants by exiting its current entanglement with Treasury.


SDI Glossary: "Bond" Definition
SDI Glossary: "the Fed" Definition
This Article's Word Cloud:   Federal   Government   Once   Reserve   There   Treasury   actions   based   called   concept   concern   contractionary   could   cover   current   demand   economic   exit   federal   government   have   infinite   inflationary   interest   least   likely   limited   lower   market   meager   point   policy   provide   rates   resources   spending   stimulus   support   that   their   this   unlimited   value   wants   what   when   will   with   would   yields

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