By David Malpass

The following is an article by David Malpass of Encima Global urging the Fed to stop buying government bonds.  It is compelling so I asked David for permission to post it on my website.  Malpass is a Former Deputy Assistant Treasury Secretary and writes regularly for Forbes and the Wall Street Journal.

In the just-released minutes from the Federal Open Market Committee’s December 14 meeting, the Fed defended its massive bond purchase program (QE2), explaining away the sharp rise in Treasury bond yields and the clear evidence that a rebound from the mid-2010 soft patch was already well underway when the Fed began buying bonds in November. Fed Chairman Bernanke is expected to make some of the same QE2 arguments when he testifies to the Senate Budget Committee on Friday, his first congressional testimony since announcing QE2.

The Fed’s rationale for buying a stunning $75 billion per month of Treasury notes and bonds (almost the entire issuance) has been its fear that the economy was slowing and its hope that Fed bond purchases would lower Treasury and corporate bond yields in a stimulative manner. Neither part of this logic is working. Bond yields have risen sharply, while recent economic data – from rising auto sales to falling jobless claims to ADP’s report yesterday that its customers added record jobs in December – is contradicting the Fed’s thesis of an economic slowdown. The Fed’s December 14 minutes still fretted about deflation even as this week’s two ISM surveys confirmed the surge in prices that is being recorded in global commodity markets.

Under the Fed’s have-it-both-ways logic – buy more bonds if growth is slow (in order to speed it up) and buy more bonds if growth is fast (on the view that bond buying is working) – the Fed’s massive new program will quickly take on a life of its own. Just as Fannie Mae and Freddie Mac became instruments of Congress’s social policy, Fed bond purchases will become one of the Executive branch’s favorite growth policies – “costless” stimulus through a huge expansion of the Fed’s turf, with minimal Congressional oversight.

A growing worry, this Fed program, like almost all other Washington power grabs, may never die. The Fed has now established the precedent that it has the power and, under its reading of its full employment mandate, the responsibility to buy long-term assets to boost the economy. The Federal Reserve System (including the regional banks) already has 22,000 employees. Its assets will soon top $3 trillion if it continues with QE2. That’s way too big for safety. Despite having little in the way of equity capital, the Fed is leveraging itself up using overnight deposits from commercial banks to buy very long-term Treasury, MBS and agency bonds. This is creating what must be history’s biggest, most leveraged maturity mismatch.

Even if the Fed stops buying bonds at its January 26 meeting, as it should, it may take years or even decades for the Fed’s existing multi-trillion dollar bond portfolio to mature and burn off. The Fed’s large bond holdings distort prices, expose the Fed (and the taxpayer) to interest rate risk, and create a conflict of interest for the Fed in setting interest rates (since rate hikes will hammer the Fed’s bond portfolio.)

The Fed is already worrying that a decision by the Fed to not buy bonds risks higher bond yields, a recipe for the Fed to buy all kinds of bonds. The Fed’s minutes from December 14 said: “In the weeks following the November meeting, yields on nominal Treasury securities increased significantly, as investors reportedly revised down their estimates of the ultimate size of the FOMC’s new asset-purchase program.” Thus, the Fed staff seemed to be blaming the rise in Treasury yields on the absence of QE3 (rather than the good news that economic growth expectations were rising in contradiction to the Fed’s growth forecast.) Following this logic, the Fed will be inundated with political requests that it buy other assets like muni bonds or infrastructure bonds in order to keep their yields from rising. Every rising bond yield can be blamed on inadequate Fed purchases.

The Fed already has a huge self-interested constituency, Wall Street, primed to support broader Fed bond purchases. The Fed’s August preannouncement of Treasury bond purchases gave the bond market a juicy buy-the-rumor, sell-the-news opportunity to buy ahead of the Fed and then use the Fed’s purchases as an exit strategy, taking a huge market profit off the Fed. This strategy also worked on the Fed’s December 2008 MBS purchase announcement, giving Wall Street a huge profit buying MBS in advance of the Fed. The cost to the economy and savers of these concentrated profits is spread across the entire system, and will grow as the Fed expands. There’ll be another round of concentrated profits whenever the Fed buys a new asset class or ultimately tries to divest itself.

The best outcome from this policy nightmare would be for Chairman Bernanke himself to wind down the program in the next few weeks and then try to set the economic history books straight – putting aside whether Fed asset purchases were justified in 2008 when the global financial system was at risk, they are not now an appropriate Fed policy tool. The Chairman has an opportunity to start signaling this on Friday, when he testifies. The only other scenarios that might stop the Fed’s bond purchases are three or more voting dissenters at an FOMC meeting, an unlikely boardroom coup that would undercut the Fed’s credibility; or such rampant inflation that even the Fed won’t be able to ignore it. Since inflation is a deeply lagging data series – the Fed was able to claim throughout the 2003-2007 monetary bubble fiasco that inflation was “moderating” even as the core PCE deflator, upon revision, was rising and always exceeded the Fed’s 2% ceiling — it’s unlikely that inflation will ride to the rescue in time, nor does anyone other than commodity buyers really want that outcome.

The Fed has a ready-made out-clause. Its December 14 statement promised: “The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.” The latest strong economic data gives the FOMC, and Congress, an opportunity to critically review the whole flawed idea of the U.S. Federal Reserve, one of the world’s bedrock financial institutions, leveraging itself to over $3 trillion in assets in a vain attempt to hold bond yields down.

David Malpass is President of Encima Global and Chairman of GrowPac.com’s Stop the Fed campaign.

Original Article Located Here.