Applied Philosophy

The composition of the Federal Reserve’s treasuries’ holdings that I discussed ten months ago (see Fed Holdings: Short vs. Long Term Securties) is now at the center of the Fed’s monetary policy:

The Federal Open Market Committee concluded its September 21, 2011 Meeting at about 2:15PM EDT by announcing the implementation of Operation Twist. This is a plan to purchase $400 billion of bonds with maturities of 6 to 30 years and selling bonds with maturities less than 3 years, thereby extending the average maturity of the Fed’s own portfolio

—History of Federal Open Market Committee actions, Wikipedia

This how the Fed’s holdings were split in January 2007:

Federal Reserve treasuries holdings January 2007: short-term in blue, long-term in red

Four years, nine months and one financial crisis later it looks like this:

Federal Reserve treasuries holdings September 2011: short-term in blue, long-term in red

Operation Twist is the implementation of the Fed’s promise to keep interest rates low until 2013. Investors do not want stable low rates, they want declining rates. Short term rates are already at zero, so longer term rates have to decline to satisfy the financial world. Interest rates have been declining since their highs 30 years (see Liquidating the Debt of the United States) and as long as they keep declining the financial structure built after Nixon closed the gold window will survive; when they start rising that structure will die and so will the fiat dollar with it.

Twisting might have once worked, but that was back in 1961 when the dollar was linked to gold. Extending the average maturity of the treasuries today means that while investors roll over their bills at higher rates, as the dollar starts to lose the remaining one percent of value it still has, the Fed will be stuck with long dated treasuries. A positive feedback loop descending all the way to zero dollar value.

If you want to make your own graphs you can use this FRED graph to get you started.

After posting in my last blog post the following graph showing the composition of the Federal Reserve’s Treasuries holdings:

The Fed's Treasury securities composition

I returned to the excellent St. Louis Fed: Economic Research website to further examine the data and produce a more concise graph. I grouped the six data series into two lines; the first (in red) shows the total face value of securities maturing from 1 year to over 10 years, so Notes and Bonds. The second (in blue) shows the total face value of securities maturing in less than a year, so Bills (maturities refer to the remaining time to maturity and not the maturity of the security at issue).

Federal Reserve treasuries holdings: short-term in blue and long-term in red.

At the start of 2007 short term securities formed the majority of the Fed’s holdings:

Federal Reserve treasuries holdings January 2007: short-term in blue, long-term in red

After almost four years, at the end of 2010, short-term Treasury debt declined to less than a tenth of the Fed’s holdings:

Federal Reserve treasuries holdings December 2010: short-term in blue, long-term in red

If you want to adapt these graphs you can use this FRED graph to get you going.

In a preliminary report released Tuesday, the U.S. Federal Reserve said it will turn over $46.1 billion to the federal government. That money comes from income the central bank received mostly from its investments in U.S. Treasury bonds and mortgage-related securities.

The Federal Reserve also made money from loans to banks and other firms.

The bank’s profits follow an unprecedented amount of spending in emergency investments.  At the end of 2009, the bank was holding more than $1.5 trillion in U.S. government debt and mortgage-related assets.

After paying operating costs, the Federal Reserve turns over all profits to the U.S. Treasury.  It returned $34.6 billion in 2007.

—US Federal Reserve Makes Record Profits in 2009 [my emphasis]

In September 2009 the Fed’s balance sheet was $2,144 billion, while in June 2007 it was $869 billion (source). Thus the profit-to-assets ratio is:

click to view

Record profits, indeed! Record low profits that it is.

The downward spiral in the German bund market widened the Euro’s interest rtate advantage over the US dollar, leaving the greenback on shaky ground and vulnerable to speculative attack. Bernanke would be under heavy pressure to match a second ECB rate hike to 4.50%, to defend the value of the dollar. In essence, the ECB could hijack US monetary policy, and force the Fed to guide the federal funds rate higher, in order to shake-out speculators in the crude oil and commodities markets.

Gary Dorsch, When Central Bankers Clash, Stock Markets can Crash

This an example of the nonsense that one has to endure when reading articles by people who are very knowledgeable about the economy and totally ignorant about everything else-the curse of over-specialisation and expert-ism-here, for example, the ECB (European Central Bank) and the Fed (Federal Reserve) are put head to head and measured as if they exist in a political/historical vacuum.
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When engineers were developing the jet engine they encountered a very strange phenomenon: while holding the fuel level, the input to their system, constant the engine at some point starts to turn faster, the output to their system; to avoid an explosion they would lower the fuel level, but the engine would keep on turning faster. At that point the engineers would stop the flow of fuel and still the engine would keep on going faster for a while and then power down.

This strange phenomenon was not only a violation of physical laws (conservation of energy, etc) but was in stark contrast to what engineers have been doing since the first steam engine: engineers usually work on getting output from their input and not the other way around. After much testing they had no other choice but to take the engine apart and see what was happening inside; tests, finally, showed the problem was in the flow of the fuel inside the fire chamber.
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