The Federal Reserve is engaging in what is nicknamed “operation twist”.  It means that the Fed is reducing its holdings of short-term treasuries and increasing its holdings of longer-term bonds.  The Fed is not claiming to expand its balance sheet with this operation.  It is merely changing the maturity dates of some of its holdings from shorter-term to longer-term.

The primary reason given by the Fed and by analysts for this move is to keep down long-term interest rates.  This will help keep down or even lower mortgage rates, as mortgage rates are highly correlated to the 10-year yield.  The Fed sees this as a way to incentivize buying in the weak housing market.  It will also encourage more people to refinance (for the few who actually can) so that their monthly payments are reduced.

I see another potential reason for the Fed doing this.  If interest rates were to rise, then it could be less harmful for the government’s debt.  Whenever a U.S. treasury reaches maturity, the Fed has to buy a new one in order to roll it over.  If its holdings are longer-term, then there will be fewer to roll over in the shorter term.  This means that the government would not have to find as many buyers for its debt, whether it is private investors, central banks (like China), or the Fed itself.

In the last FOMC meeting, it was indicated that the Fed will continue this operation twist.  I discussed the FOMC’s meeting and some of Bernanke’s comments here.

Here is the problem.  There ain’t no such thing as a free lunch (TANSTAAFL).  Maybe Bernanke and the Fed think they are being smart here and doing things that can only help, but there are potential consequences.

The main bad consequence that I see coming from this policy is that it increases the likelihood of severe inflation.  If interest rates were to start rising, then the value of bonds would go down.  That means that the Fed’s holdings would go down.

If the Fed held shorter-term treasuries and interest rates were to rise while price inflation started getting out of control, then the Fed could just simply reduce its balance sheet by not rolling over its maturing assets.  Of course, this would serve notice to Congress that government spending needed to be cut quickly as the Fed would no longer be funding the big deficits, but at least the Fed would be capable of having an “exit strategy”.

If the Fed has longer-term bonds in its holdings and interest rates go up while price inflation is getting out of control, what is the Fed going to do then?  If it sells its bonds, they will be worth much less.  This will drive up interest rates even more as it is forced to sell even more.  Also, because the values will be down so much with the higher interest rates, who knows if the Fed can even sell enough to reduce its balance sheet significantly enough to stop the price inflation.

Back in 2008, the Fed bailed out the banks by buying their bad assets.  These assets can’t be sold today for what the Fed bought them.  These were mortgage-backed securities and many of these mortgages have gone into default.  These securities are worth much less now than they were before the financial crisis showed up.

In conclusion, maybe Bernanke and the Fed think they are being smart with their operation twist.  But they really are just adding fuel for the fire that will be coming.  They are putting everyone at risk by increasing the likelihood that it will not be able to control price inflation when it shows up in a big way.  It will also make for a harder crash for the federal government when it can no longer rely on the Fed to fund its massive deficits.