The Recent Fed Announcement

The Federal Reserve has come out with an incredible announcement. (see http://online.wsj.com/mdcapp/public/page/2_3024-info_fedparse_shell.html) While the headline number of 0 to 25bps interest rates that banks can borrow is important and unusual, it is not the heart of the release. What is dramatic is that the Fed is going to target longer term interest rates. While I am not a macro economist, this is going to be interesting to see if they can achieve such targeting.

The problem is that to drive interest rates lower, they must purchase long-dated loans by printing money. At some point, the amount of money in the system will increase prices. At that point, any investor who purchases say 10-year treasuries is going to receive far less money than the original principle. For example, you buy $1 million of 10-year treasuries. Inflation increases by 10% per year in the very last year. All other years inflation is zero and the interest rate is 3%. That means for nine years you get 3% rate of return and the last year you get a negative 7%. That is not a good investment and you will suffer a loss (if not in raw cash, in a net present value sense.) Thus, the idea that the Fed can control long rates is questionable. In the entire history of the world, no central bank has been able to control long rates for more than very short (weeks) periods of time. At some point the very act of trying to control long rates is counter-productive.

What conclusions can you reach about the FED statement? They are really worried. They are throwing everything including the kitchen sink into the fight. They are using every bullet they have and are borrowing a few from others! What happens if something else happens? What else can the FED do? THey have used everything to fight the current battles and they are risking something even more important- their credibility. If the economy does not respond quickly, their might be a really significant fall in the stock market as there is nothing left for the FED to do. As more than a few people have said: They are ALL IN. Nothing left to do but execute. That has to be scary for every investor.