The Fed Gives the Treasury a Gift
Timothy Geithner, and the rest of the Obama Team, should send a thank you note to Ben Bernanke at the Federal Reserve.  Thanks to today's announcement from the Fed, the US Treasury will pay even lower interest rates to finance its burgeoning debt levels.

The Federal Open Market Committee (FOMC) bowed to unwarranted fears of a double-dip recession.  Rather than allowing its balance sheet to shrink, it agreed to buy longer-term Treasury bonds with any principal payments it receives from its vast holdings of mortgage backed securities.  At the same time, the Fed announced that it will roll over any current holdings of Treasury securities as they mature.

The 2-year Treasury yield fell roughly 2 basis points (to, 0.52%), the 5-year fell 8 bps (to, 1.45%), and the 10-year fell 6 bps (to, 2.77%).  The 30-year Treasury bond barely moved, but is yielding just 4.0%, one of the lowest yields on record – outside of the panic lows of late 2008 and early 2009.

With rates so low, the US Treasury is paying $230 billion less in interest per year than it would pay if rates were at levels that existed back in 2007 – just three years ago.  Because the Fed has once again stated that it will hold the federal funds rate near zero for an "extended period" and because the Fed will step up its purchases of Treasury bonds, yields will likely remain near record lows.  This masks the real cost of government debt.

For the fifth consecutive meeting, Thomas Hoenig, President of the Kansas City Federal Reserve Bank, dissented from both decisions of the FOMC.  He believes that the "extended period" language is "no longer warranted."  At the same time, he did not believe that maintaining the Fed's balance sheet at the current level was "required to support a return to Committee's policy objectives."

We agree with Thomas Hoenig.  In fact, he is our hero.  The odds of a double dip recession are extremely low.  The risk of inflation is rising.  And, the Federal Reserve should not be monetizing the debt of the US Treasury.  The Federal Reserve cannot prop up the economy using money without causing long-term damage to the value of the dollar and US purchasing power.

What the Fed should do and what the Fed will do are two different things.  First Trust models suggest that the natural rate of interest – the level of the federal funds rate that would not boost inflation, or hurt growth – is roughly 1% and rising.  A perfect policy would be pushing rates to that level right now.  However, it is clear that the Fed is in no mood to lift rates and will likely hold them steady well into 2011.

Holding rates steady means that the Fed will become more accommodative as the year progresses.  As a result, Fed policy will cause both growth and inflation to accelerate throughout 2010 and into 2011.  The bond market is stuck between a rock and a hard place.  Fed policy on one hand is pulling rates down, while growth and inflation will push rates up.  In the end, the Fed will lose this battle.  Easy monetary policy eventually results in higher interest rates down the road. 

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Posted on Wednesday, August 11, 2010 @ 8:13 AM

These posts were prepared by First Trust Advisors L.P., and reflect the current opinion of the authors. They are based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.