09.22.2011 0

The Fed Twists Itself into a Pretzel

By Bill WilsonOn Sept. 21, the Federal Reserve announced its latest plan to “[t]o support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate”.

Dubbed Operation Twist after the famous 1960’s dance, this time the Fed plans to sell $400 billion of short-term U.S. treasuries of up to three-year maturities, and exchange them for $400 billion of long-term debt, with maturities of six to thirty years.

Ostensibly, the purpose of the plan is to “put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative.” Which, according to Fed head Ben Bernanke and the Fed’s Open Market Committee, is apparently supposed to help the economy.  How?

You’d have to ask the Fed.  But, interest rates are already low and have been for some time.  For example, the Federal Funds Rate — the interest rate that the Fed and other banks lend to each other at — has been near-zero since December 2008.

This, too, was supposed to foster the recovery, but almost three years later — with unemployment persistently high at over 9 percent, and growth sluggish at a little more than 1 percent — there is little evidence to suggest that pushing interest rates down has accomplished anything positive at all.

All the Fed’s new plan may do is simply keeping rates where they’re at — which is low.  But the downside risks to this approach are well-known.

For example, the Fed’s super-low interest rates in the 2000’s helped produced the housing bubble, which, when it popped, wrecked the economy, resulted in a depressed housing market, high unemployment, and budget deficits as far as the eye can see.  The Fed’s easy money policies have also been attributed to the higher prices food, energy, and other commodities, including metals, seen in the past few years.

Overseas, ultra-low interest rates were utilized by Japan after its economy turned south in 1989 — and over twenty years later it has never come back.

So, if artificially low interest rates are not an economic panacea; if they will not “support a stronger economic recovery” or do anything to control inflation, then why else might the Fed be pursuing this policy?

We should look no further than the rapidly climbing $14.7 trillion national debt.  If the rates on long-term treasuries are low, then the government can keep its borrowing costs lower than they might have been otherwise if the markets were determining interest rates.

For example, in 2021, the Office of Management and Budget projects the national debt will have spiraled up to $26 trillion.  Spread out over 30 years, that means annual principal owed will total $866 billion, a growing amount that will always need to be refinanced — unless we commit to repayment as a policy.

If interest rates on treasuries are held down to, say, 2 percent, gross interest owed on the debt would rise to $520 billion annually by the end of the decade.  That compares with $430 billion in gross interest paid today at an effective rate of about 3 percent.  That would be a 20 percent increase.

Conversely, if rates were to normalize at 5 percent, the interest owed on the debt would jump to an astronomical $1.3 trillion in 2021, a 200 percent increase.  Add to that the principal owed, plus an annual deficit of perhaps another $1.5 trillion, and the Treasury would have to sell about $3.666 trillion in debt that year alone just to make ends meet.

That compares with $2.886 trillion of necessary treasuries sales if the Fed manages to hold at the 2 percent average rate, and with today’s approximate $2.420 trillion principal-interest-deficit financing obligation.

But all of that assumes that the Office of Management and Budget’s rosy economic growth and revenue projections even come true.  If they don’t, then all bets are off.  For example, if growth remains anemic or worse, we go into recession, and revenues only rise to $3.5 trillion by 2021 instead of $4.8 trillion as projected by the government, the debt would be around $35 trillion instead of $26 trillion.

If that happens, the Fed might be expected to try to push interest rates down even further — the whole time assuring us that they are trying to foster an economic recovery.

Except it has nothing to do with growing the economy — the Fed twisting itself into a pretzel to claim otherwise notwithstanding.  This move is a bailout of the federal government, and serves notice to the nation’s creditors to expect less of a return on lending to the U.S.

It is simply an attempt to keep sovereign debt a “risk-free” proposition — at least for a little while longer.

Bill Wilson is the President of Americans for Limited Government. You can follow Bill on Twitter at @BillWilsonALG.

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