Everything You Know About What the Fed Is Doing May Be Wrong

The economy and financial markets are really complicated. But there's always an easy fix for complicated things: Simplify!

Right now, the simplified logic on what the Federal Reserve is doing to the economy goes like this: By buying up hundreds of billions of dollars of Treasury bonds, the Fed is pushing interest rates down. And by scooping up those Treasury bonds, the Fed is financing the federal government's massive budget deficits.

Both are true, but only kind of. Simplifying doesn't tell us the whole story.  

Take interest rates.

The Fed has played around with quantitative easing for the last four and half years. But during that time it's gone in fits and starts, engaging in QE, then stopping, then starting up again. There have been several periods since 2008 when the Fed has purchased huge amounts of Treasuries and mortgage-backed securities, and several periods when it purchased no bonds all, leaving the market to itself.

Now, it would make sense that when the Treasury was buying government bonds, interest rates should have dropped -- that's the process of keeping interest rates artificially low. And it therefore makes sense that interest rates should have risen when the Fed ended its QE policies, as the free market found the right price.

But neither occurred.

It's actually been the other way around.

Every time the Fed has begun a new QE program, interest rates have gone up. And every time that program has ended, interest rates have gone down. Every. Single. Time:

Source: Federal Reserve, Calculated Risk.

How is this possible?

One explanation is that the Fed entering the Treasury market displaces more capital than it brings in. So, if the Fed steps in with $100 billion of Treasury purchases, but by doing so chases away $120 billion of private capital that would otherwise be buying Treasuries, the net impact on marginal buyers can be down. Also, the Fed announces the start and stop dates of its QE programs well before they occur, so the private market can price in events before they actually happen. As the saying goes, buy the rumor, sell the news.

Next, we hear a lot about how the Fed's Treasury purchases are helping the government finance its deficit. As economist Lawrence Lindsey said last year, "they are buying the entire deficit."

But again, it's not that simple. While the Fed is buying a lot of Treasury bonds, it sold a massive amount in late 2008 to make room on its balance sheet to bail out Wall Street. All the while, private investors around the world have been buying Treasuries like there's no tomorrow.

The result is that the Fed's ownership share of Treasury bonds outstanding is actually lower today that it was a decade ago:

Source: Securities Industry and Financial Markets Association, author's calculations.

"The truth is rarely pure and never simple," said Oscar Wilde. That's especially true with Fed policy. 


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  • Report this Comment On April 30, 2013, at 3:08 PM, slpmn wrote:

    That's really interesting. Makes me wonder about the pricing when the Fed makes purchases for its QE programs. Obviously, it's not a normal market particpant like other large bond players. If rates are going up while it's buying, that means prices are going down, which doesn't make sense. Unless the Fed is dictating a below market price for it's purchases and influencing the broader market that way. But that raises the question of whether it's intentional, or just a by product of the mechanics of arranging the purchase of 10s of billions in bonds over a set period of time.

  • Report this Comment On May 01, 2013, at 1:48 PM, SkepikI wrote:

    Well, that is marginally interesting (ha) Morgan... BUT if the world knows that the Fed is, was and will be buying massive quantities of Bonds even when the yields are tiny, there will be no bids and no demand for higher rates on Bonds. Until the landscape changes, and the Fed QUITS, the market is constrained, margins are set and you would be crazy to take a chance you can get better returns.

  • Report this Comment On May 01, 2013, at 2:06 PM, SkepikI wrote:

    Actually, we could all try an amusing thought experiment... Lets say a bunch of monkeys, chimps and gorillas are in the market for, oh say bananas.... and the biggest baddest 800 lb gorilla announces to all that he will only pay a penny per banana, and withhold a punch to the head for any competition from the monkeys and chimps as long as they obey the price signal The chimps and monkeys are hungry for bananas but really think they are worth two cents and they are comatose from not having enough to eat.. The chimps would like to grab some bananas and sell them to the monkeys for two cents, but there are few for sale. And then there is the fact they are prevented by the market from selling over a penny and only what they can manage to buy when the gorilla doesn't buy every banana on the market. Then there is the one two punch of the 800 lb gorilla (no pun intended) who sells the occasional one penny banana to the hungry monkeys and promises retribution for chimps who don't toe the line. The gorilla doesn't sell the monkeys or chimps enough to satisfy them, just enough to keep them comatose and unable to revolt....

    How long can the 800 lb gorilla keep this up and when does the price of bananas rise to 2 cents?

    Post your own answers!!! Mine is when the gorilla gets constipated from too many bananas and decides he just cant stand buying bananas anymore, or they start to spoil and he has to sell to the chimps...

  • Report this Comment On May 02, 2013, at 4:00 PM, boogerface02211 wrote:

    Keep up the darn good work, Morgan. Your articles have displaced my other investment reading.

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