All Treasuries All the Time: The Impact of QE2

So… This is what life after “QE2” looks like:

  • Record gold prices
  • Stocks back at pre-Lehman levels
  • And a dollar cruising toward its 2008 lows.

Everything is rallying…in terms of depreciating dollars. Mission accomplished. Ben Bernanke needs George W. Bush’s ol’ “shock and awe” flak jacket.

In case mainstream media coverage made you glaze over, here’s the quick and dirty of the Federal Reserve’s fateful decision…

  • The Fed will buy $600 billion in Treasuries over the next 8 months
  • The mortgage securities the Fed bought during QE1 now reaching maturity will continue to be rolled over into Treasuries, as they have been since August. That’s another $275 billion, give or take
  • There was also the caveat that more of this could be in the works if unemployment stays high and inflation (as defined by core CPI) stays low.

Hmmn… If the federal budget deficit is supposed to run $1.2 trillion during fiscal 2011 (that’s the consensus guess)…and the Fed will purchase $875 billion in Treasuries over the next eight months (that’s two-thirds of a year)…

[Pause for back-of-the-envelope math]

…then we quickly see the Fed plans to monetize all of all the debt that Treasury plans to spit out from now through the middle of next year, and then some.

This is yet another reason we don’t expect the House Republicans to convert to the gospel of fiscal responsibility any more than they did last time they were in the majority: They can indulge in demon spending unto oblivion…and the Fed will have their back.

“If this were Greece or Ireland,” Bill Bonner wrote yesterday before the announcement, “the government would be forced to cut back. With quantitative easing ready, there is no need to face the music. If bond buyers will not finance America’s trip to bankruptcy, the Fed will provide as much brand-spanking-new money as necessary.”

The main difference between QE2 and its predecessor is this: The bulk of the junk the Fed put on its balance sheet during QE1 was mortgage securities, with about $300 billion of Treasuries thrown in for good measure. Now it’s all Treasuries, all the time.

And most of those Treasuries are of medium-term duration – very few 30-year bonds are in the mix. Thus, the yield on the long bond rocketed past 4% yesterday. It sits at 4.05% as we write.

Still, what’s really notable about QE2 is the form it did not take. In August, former Fed vice chair Alan Blinder wrote an Op-Ed in The Wall Street Journal. He tossed out a number of suggestions for QE2 that, for better or worse, would actually goose the economy and not just shore up the banks’ balance sheets:

  • The Fed could buy assets beyond the realm of Treasuries and mortgage securities. It could buy corporate bonds, small business loans, or credit card receivables
  • The Fed could stop paying interest on excess reserves to member banks. And if that didn’t encourage them to make more loans…
  • The Fed could start charging the banks interest to stash their excess reserves.

Yesterday, the Fed chose “none of the above.”

It didn’t even take up Blinder on his suggestion to adopt new language hinting at an even-longer lasting commitment to near-zero rates. We just got the same old blather about “exceptionally low” rates “for an extended period.”



“Today,” Fed chief Ben Bernanke wrote in this morning’s Washington Post by way of explaining himself, “most measures of underlying inflation are running somewhat below 2%, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run.”

Of course, that “underlying” inflation level does not take into account your need to eat, or heat your home or drive to work.

And it’s only going to get worse. Your neighborhood grocer is seeing his costs rising. “The big challenge,” says the CEO of a California grocery chain to The Wall Street Journal, “will be how much can we swallow and how much can we pass along?”

He’s holding out as long as he can, but skimping on tires for your delivery trucks (seriously, that’s one of his cost-cutting measures) only gets you so far.

Yesterday, we discussed rising food, gold and commodities costs in the context of the Fed decision during this interview with Financial Survival Radio. Have a listen here:

Addison Wiggin
for The Daily Reckoning

The Daily Reckoning