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Minyan Mailbag - Federal Reserve & Bonds



Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next column with that very intent.

Prof. Succo,

You had a post that stated the following [also part of a conversation entitled Buzz Flation]:

"I am in agreement, Scott, on your points about deflation (although I think stagflation is what we will have) as the ultimate environment.

The excesses only have been increased. The Fed has only provided a dose of morphine, not a cure. The cure is too painful for bureaucrats.
I only disagreed on timing. I think the Fed at this point cannot allow an all out run on the dollar and have to attempt at first to stabilize it. This also gives them a higher base from which to "begin" easing (I actually think they never stopped; they just bought long bonds with the money)."

I understand that because the Federal Reserve targets interest rates that they must add or remove dollars from the financial system accordingly.

Could you please explain the mechanics and implications in that last part of the last sentence in parenthesis ("they just bought long bonds with the money.")?

They are removing dollars from the financial system to increase interest rates and with those dollars, they are buying long bonds? What are the implications of that (short and long term)? Wouldn't that cause the yield curve to flatten?

I am very interested in this. Thank you in advance.

Minyan Ryan


I believe that they are still running a loose monetary policy despite raising short term rates. Through swap agreements, they can at the same time as raising short term rates, purchase longer maturity U.S. treasury bonds. This puts liquidity into the system: the sellers of the bonds now have cash.

This does flatten the yield curve. The damage done by rising short term rates is minimal as long as long term rates do not rise commensurately. It is a strange phenomenon indeed to not see a parallel shift as short term rates rise. That is evidence of this type of intervention.

Prof. Succo

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