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

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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. 

The article Everything You Know About What the Fed Is Doing May Be Wrong originally appeared on Fool.com.

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