Looking at a Schiff Storm Ahead

Peter Schiff issued a dire outlook on Fed policy this weekend, with a piece at RealClearMarkets. Last week, the FOMC launched “operation twist,” shifting its holdings of Treasuries from short-term to long-term debt in an effort to push down long-term interest rates. James Groth responded with a cutting post about the exasperation we feel at the Fed’s inept practice of monetary policy. I noted the irony of the following day’s market response. In a more formal critique, Schiff argues:

The policy rests on the false premise moving already historically low interest rates even lower will stimulate the economy into recovery. But low interest rates are part of the problem, not part of the solution.

What could the benefits possibly be? Lower mortgage rates aren’t going to help matters much. There aren’t families lined up to by homes as soon as that 4% rate becomes 3.5%. The goal is more stimulus, but even if attainable (which it is likely not) we’ve been critical of QE3 because stimulus is not what we need. Schiff argues,

the stimulus itself is causing the economic weakness. As a result when the economy deteriorates, support for QE III could grow. In the end QE3 will likely be far more popular than another bank bailout (possibly to be called TARP II), which may be on the table if the Fed fails to rescue the banks it may be pushing over the edge with the Twist.

How might the Fed go over the edge?

The Fed severely underestimates the danger of loading up its own balance sheet with long dated securities. Not only does the move expose the Fed to severe losses when interest rates inevitably rise, but it drastically reduces its ability to withdraw liquidity to fight inflation. Short-term securities provided flexibility as they could be sold into a falling market with little price risk, or if need be, held to maturity. Such options do not exist with bonds maturing in 6-30 years. So when inflation continues to rise, as I’m sure it will, the Fed will be powerless to slow it without crushing the bond market and causing yields to soar.

Schiff’s conclusion solution is the same as what we’ve been arguing for years on this blog:

Our zombie economy… must be allowed to die so that a living, breathing, self-sustaining economy can replace it. By feeding our addiction now the Fed is impeding the recovery. QE may goose the markets and provide a short-term boost to spending, but it will also increase debt and grow the government. This process exacerbates the structural imbalances underlying the U.S. economy, making what may be the inevitable crash that much more spectacular.

Read the whole Schiff piece here.