REVEALED: The Fed’s Next Trick

Today we lower our ear to the rail… and report the approach of a rumbling locomotive.

Free and honest markets are roped to the tracks, squirming, writhing, sobbing.

This iron horse is barreling toward them. Mr. Jerome Powell is at the controls…

And murder is on his mind.

What is the Federal Reserve’s latest plot against the remains of free and honest markets?

And will it pull off the caper?

Answers anon.

We first look in on the seemingly condemned — squirming, writhing, sobbing on the tracks…

A Quiet Day on Wall Street

The day counted plus and minus.

The Dow Jones lost 39 points. The S&P scratched out a 1.85-point gain today. The Nasdaq, meantime, took the ribbon with a 32-point advance.

A dull affair altogether. Yet tomorrow may bring high adventure of course.

And so we now return to today’s central question:

What is the Federal Reserve’s latest plot against the remains of free and honest markets?

Let us first flip back the calendar to the war year of 1942… where our tale begins.

How the Fed Fought WWII

Wars are costly enterprises. And taxes alone would not purchase the arsenals of democracy.

Uncle Samuel therefore held his cap before the bond market… and went upon the borrow.

But the authorities were hot to keep borrowing costs within reasonable limits.

The Federal Reserve and the Treasury Department therefore signed onto an agreement:

The Federal Reserve would place a cap on the government’s borrowing costs.

This it accomplished by purchasing any government bond with yields above a predetermined level.

These purchases shrunk the yield (purchasing Treasuries hammers down the yield; selling Treasuries ratchets yields higher).

If the 3-month Treasury bill yielded above 0.50% — for example — the Federal Reserve purchased 3-month Treasury bills until yields fell to 0.50% or below.

If longer-dated Treasury yields exceeded 2.5%… the Federal Reserve purchase longer-dated Treasuries until yields dropped to 2.5% or lower.

Thus borrowing costs were clamped to tolerable levels.

The Fed Cedes Monetary Policy to the Treasury

The proper term for the business is “yield curve control” (more on which below).

The Federal Reserve — in essence — ceded monetary policy to the United States Department of Treasury.

The Federal Reserve likewise surrendered control of its balance sheet, notes Jim Rickards:

The cap also meant that the Fed surrendered control of its balance sheet because it would have to buy potentially unlimited amounts of Treasury debt to implement the rate cap. (Such asset purchases had inflationary potential, but in World War II, inflation was managed separately through wartime price controls.)

The monetary base doubled between 1942–45… incidentally.

The Federal Reserve continued to abdicate its responsibility for monetary policy until 1950.

Now come home…

The Fed’s Fighting a New War

It is the year of pandemic. To battle its economic catastrophes, the Federal Reserve has reset its target interest rate to zero.

Thus interest rate policy is… limited.

Might our adventuresome central bank wade into the dense swamp of negative rates?

It may — in these pages we have maintained it will. Yet to date it has heaved the wet blanket upon all speculation of them.

And negative interest rates have not met advertising where attempted — in Japan and parts of Europe primarily.

How then can the Federal Reserve coax the reluctant economic machinery to life… and stuff down borrowing costs?

Yield curve control — the same yield curve control that financed the Second World War.

The Fed Would Take Direct Control of Interest Rates

In reminder, the yield curve plots bond yields across the spectrum — from short-term bonds to long-term bonds.

Yet this you must understand:

The Federal Reserve only fixes the federal funds rate. That is the “overnight” rate banks charge one another to borrow.

That is, the Federal Reserve’s actual control over interest rates is limited.

It influences longer-term rates, nudges them, leans on them, blows against them.

But it does not control them… to its everlasting disappointment.

And longer-term rates unlock the grails of borrowing and consumption.

How can the Federal Reserve seize direct control of longer-term rates?

Yield curve control.

Targeting Longer-Term Yields

Assume a particular Treasury yield exceeds the Federal Reserve’s preferences.

It can then purchase and purchase that particular Treasury until yields sink to its liking.

Explains one Sage Belz — and another David Wessel — they of the Brookings Institution:

In normal times, the Fed steers the economy by raising or lowering very short-term interest rates, such as the rate that banks earn on their overnight deposits. Under yield curve control (YCC), the Fed would target some longer-term rate and pledge to buy enough long-term bonds to keep the rate from rising above its target. This would be one way for the Fed to stimulate the economy if bringing short-term rates to zero isn’t enough.

And that is lovely because:

Lower interest rates on Treasury securities would feed through to lower interest rates on mortgages, car loans and corporate debt, as well as higher stock prices and a cheaper dollar. All these changes help encourage spending and investment by businesses and households. Recent research suggests that pinning medium-term rates to a low level once the federal funds rate hits zero would help the economy recover faster after a recession.

Meantime, the federal government is piling up debt at rates truly fantastic…

Bottling Borrowing Costs

The federal deficit in the current year may well exceed $4 trillion. And trillion-dollar deficits stretch to the farthest horizon.

The authorities are therefore keen to bottle interest rates… lest borrowing costs rise and become a millstone about the neck.

Yield curve control permits the Federal Reserve to throttle borrowing costs.

“Wait one minute,” you say. “Are you not describing quantitative easing? The Fed purchased Treasuries and other assets to drive down yields. What’s so different about this yield curve control?”

Precisely correct you are. But quantitative easing did not grant the Federal Reserve direct control over rates.

Yield curve control — as the title faintly suggests — does.

It’s All About the Yield

The Federal Reserve would purchase the requisite number of bonds to hammer yields to its desired level.

If 100 bonds fails to work the trick, then 1,000 bonds it will be. If 1,000 bonds proves inadequate to purposes, then 10,000 it will be… all the way up to a million or more.

Michael Lebowitz and Jack Scott of Real Investment Advice:

Assume the Fed set a 0.75% target yield on the 10-year U.S. Treasury note. They can then employ QE in any amount needed to buy 10-year notes when the rate exceeds that level. If successful, the rate would never exceed 0.75% as traders would learn not to fight the Fed.

Thus “Don’t fight the Fed” would assume an even greater ferocity.

Is this yield curve control in the offing?

“Whatever It Takes”

The Federal Reserve Bank of New York president — Mr. John Williams — says he and his fellows are “thinking very hard” about it.

We have no doubt they are… to the extent that they are capable of thinking very hard.

Our spies in Washington inform us the Federal Reserve will hatch its yield curve control operation later this year — for what it is worth.

Jim Rickards likewise believes yield curve control is coming:

The Fed and Treasury will reach a new secret accord, just as they did in 1942. Under this new accord, the U.S. government could run larger deficits to finance stimulus-type spending…

The Fed can use open market operations in the form of bond buying to achieve the rate caps. This means the Fed would not only give up control of interest rates, but it would give up control of its balance sheet. A rate cap requires a “whatever it takes” approach to Treasury note purchases.

“Whatever it takes.” We suspect “it” will take much. Then some more.

And so we will have more manipulation. More distortion. More fraud.

Reduce the thing to its core and this is what you will find:

The Federal Reserve attempts to fix the price of the dearest commodity of all — the price of time itself.

What king ever sought such power?


Brian Maher
Managing editor, The Daily Reckoning

The Daily Reckoning