Midnight Musing: Can the US End Up Owning Itself?

We have been pondering the Fed’s control over interest rates, why it is possible and more importantly, what are the limits.

Short term rates are determined by the effective fed funds rate (EFF rate). Manipulation of this rate has been the primary tool the Fed has used to manipulate the economy (we have written about this in Living In a Hypothesis – see Figure 6.). The problem is in 2009, the EFF rate became zero (ZIRP) and broke. It lost its stimulative capability. The Fed then resorted to different forms of QE to try and stimulate the economy. In particular, various forms of “Operation Twist” have brought down rates to historic lows across the yield curve in areas the Fed had never worked before.

The Fed has done this by aggressively buying Treasuries of whatever term it wished to influence. This drove up prices and inversely drove down yields. In such a market, an entity holding a treasury instrument may receive a hansom capital gain on selling it at a higher price than what he paid for it so the fed has no trouble finding assets to buy.

In a normal market, a rational player will bid up the price of an asset to acquire more of it, presumably for a benefit of personal consumption or production. The Fed, however is not a rational player – at least not  in the above sense. The Fed is bidding up the price of Treasuries for the sake of creating higher prices and hence lower yields. This is strictly market manipulation. Certainly other players engage in the manipulation of markets for gain as a sole objective, but the Fed is different in that they realize no gain other than a policy objective. Any attempt by markets to create their own interest rate levels is immediately thwarted by the Fed’s intervention.

Could a situation arise whereby the Fed must buy increasingly larger quantities of treasuries to keep a lid on yields (think Mario Draghi and the debt of Italy and Spain)? Although the Fed is nominally independent of the US government, in a crunch it would be perceived as an extension of it. In the extreme then, the Fed would hold all the outstanding debt of the US. The US would own itself.

Europe Is Closer

We have been watching European banks loading up on European sovereign debt. In Spain, the capital crisis in banks created by mushrooming interest rates has already forced a bank bailout. If Mario Draghi gets his way, we shall see the ECB acquire large amounts of Spanish debt. If private investors cannot find the confidence to invest in sovereign debt then the ECB must acquire it all. The ECB in principle could end up owning several European countries.

We recognize that this is an extreme linear projection and natural systems develop adaptive mechanisms, usually long before the hypothetical extremum is reached. We simply lack the experience with such disequilibrium states to even guess what the outcome might be.

Update 20120919

Read Flash Point: We’re Not the Only Ones Thinking This ….

 

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