Welcome to our Friday mailbag edition!
Every week, we receive great questions from your fellow readers. And every Friday, I answer as many as I can.
This week, readers question the Federal Reserve’s “endgame” in the permanent distortion it has created…
I have carefully studied your excellent explanations about the evolving distortion. My question: The Fed is not a charity organization. So it asks the Treasury Secretary to give the corresponding amount of financial assets – mainly Treasury Bonds and mortgage-backed securities – before “printing” more money.
The Fed asks, in addition, a solid processing fee for the process. As a consequence, the government’s debts are further increasing. But it also means that the Fed is increasingly owning the financial assets in question, which means owing the U.S. government, if I am correct.
What is the endgame of such an evolution?
– Erwin S.
Hi, Erwin. First of all, thank you very much for writing in. Regarding the endgame, here is my belief…
In these distorted times, one of the Fed’s unspoken functions is to enable the government to finance the budget (issue debt) as cheaply as possible.
If the Federal Reserve keeps interest rates relatively low (they have been as high as 20% in the past), this keeps the amount of interest the U.S. government has to pay on its debt low.
That’s a game in itself, beginning and end.
In addition, the Fed is in the unique position of being able to flood Wall Street with cash. That’s because it has the ability to decide when to cut interest rates or buy more bonds from Wall Street, without any limit.
And it also helps the government fund itself more cheaply than it might otherwise be able to do if it just relied on the capital markets.
It’s all part of the Fed’s smoke-and-mirrors management of our finances, which brings us to our next question…
I can’t for the life of me understand how any money is created when the Federal Reserve buys bonds from the banks.
The Fed creates money to pay the banks for these bonds. But how do the banks get these bonds in the first place? Don’t they have to pay the Treasury for them? Or are they just given to them free of charge?
– Thomas R.
Hi Thomas, thank you for your question. It’s certainly a head-scratcher, on many levels. But I’ll try to explain it as simply as I can…
The U.S. Department of the Treasury borrows money by issuing a Treasury bond and agreeing to pay interest on that bond in return.
Treasury bonds are considered high-quality bonds, given that they have the implicit backing (what’s called the “full faith and credit”) of the U.S. government.
The banks are given a portion of each new bond issuance to sell to customers – usually pension funds, corporations, and money managers.
And when I say “given,” I mean “allocated” by the Department of the Treasury. The big banks are considered “primary dealers.” They act as middlemen or brokers to the types of institutional customers I mentioned above.
Usually (but not always), the bigger the bank, the bigger the allocation.
And when the banks sell those bonds, they get a fee.
They can then do what they want with the money they get from the pension funds, etc. They don’t have to return any of that money to the Department of the Treasury.
It’s basically free money to Wall Street.
The Department of the Treasury doesn’t keep its own bonds, however. The idea is to sell them and pay interest on them to the end holders, whether that’s the big banks’ customers or the big banks themselves.
The banks can also keep, or hold, some of the bonds they are given on their own books to sell at a later date. They would choose to do this if they wanted to keep some of those bonds on reserve at the Federal Reserve in case of emergency or crisis.
Technically, though, as we’ve seen, the Fed pays extra money in the form of quantitative easing (QE) in return for the bonds.
This means the Fed “buys” these bonds from the banks in return for cash it has fabricated out of thin air. With a few keystrokes on a computer, it transfers that fabricated money to the bank.
So the Fed adds real bonds to its book of assets. And it adds fabricated money into the banking system.
It’s really that simple… and that crazy.
It’s a triangle. The government “borrows” money through issuing bonds… the banks are the middlemen that sell those bonds (for a fee)… and the Fed is one of the main buyers.
I hope this helps you understand the intricacies of the Fed’s QE monetary strategy.
And that’s all for this week’s mailbag! Thanks to everyone who wrote in.
If I didn’t get to your question this week, look out for my response in a future Friday mailbag edition.
I do my best to respond to as many of your questions and comments as I can. Just remember, I can’t give personal investment advice.
And if there are any other topics you’d like me to write about, I’d love to hear from you. Write me at [email protected].
Happy investing… and have a fantastic weekend!
Regards,
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Nomi Prins
Editor, Inside Wall Street with Nomi Prins