Federal Reserve's 'Sterilized' QE3 May Get Messy

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NEW YORK (TheStreet) -- Reports that the Federal Reserve is toying with the idea of a "sterilized" U.S. Treasury bond trade as a way to push liquidity into the markets without igniting inflation sounds like a great deal.

Which, as it turns out, is exactly the point: Flood the economy with money without sounding inflationary alarm and causing equity investors to flee the U.S. markets in droves.

Under the proposed third quantitative easing plan (QE3), first reported by The Wall Street Journal, the Fed will buy mortgage-backed securities (MBS) and longer-dated U.S. Treasury bonds. That would give big investors already loaded up with Treasuries additional buying power, pushing down long-term yields and freeing up capital.

The Federal Reserve will pay for the program by doing what central banks do best -- printing money. But turning up the Fed printing presses is the first signal to the equity markets that asset-destroying inflation can't be far behind.

Any stimulus would be canceled out by a stock market swoon.

In order to dance around the specter of inflation, the Fed would then "sterilize" the trade by locking up the bonds with the buyers for a short period of a month or less. That would, in theory, damn up the liquidity at the source and keep from it flooding into the broader economy where it would push up prices.

The sterilization part of the Fed's trade idea is known as a reverse repurchase agreement, or reverse repo, and its entire purpose is to convince the stock market that inflation is off the table, said Arvind Krishnamurthy, professor of finance at the Kellogg School of Management at Northwestern University.

"From the Fed's viewpoint, the market drives inflation expectations, so the Fed cares what the market thinks," Krishnamurthy said. "The Fed is trying to do a large asset purchase and wants to convince the market it does not want to inflate."

Goldman Sachs economist Zach Pandi also agreed that the sterilized QE3 is all about the perceptions of the stock and commodities markets.

"If a subset of the population holds these beliefs -- wrongly or not -- unsterilized QE could affect inflation expectations and possibly commodity prices beyond its impact on the growth outlook," Pandi said in a note cited in Thursday's Journal. "Sterilizing may therefore be a low-cost way to avoid, or at least to hedge against, possible negative side effects of further easing action."

The Fed's plans aren't without risks.

First, under the proposal it would mean the Federal Reserve would trade directly with the money market industry. In previous attempts -- QE1, QE2 and Operation Twist -- the Fed only traded with "primary dealers." Those included some of the largest U.S. and international commercial banks, including Citigroup , JPMorgan Chase and Bank of America .

That means banks would no longer be direct beneficiaries of the Fed's liquidity largess which, according to Krishnamurthy, while risky is not necessarily a bad thing.

"The Fed would like to test bypassing commercial banks and go straight to the money funds. The Fed does so much with the banks that some diversification is really critical," Krishnamurthy said.

Also, by convincing money funds to buy up longer dated bonds it could push them out of the commercial paper market, a critical source of funding for companies as large as General Electric to middle market manufacturers.

"If I am a money market fund with bunch of cash, I can either go into commercial paper or I can get the same yield with Fed as the counterparty and have Treasuries as collateral on a repo," Krishnamurthy said. "It doesn't get much better than that, and it could easily crowd out commercial paper."

Krishnamurthy ends up being in favor of the new Fed program, even if the stated purpose is about controlling stock market perceptions rather than addressing underlying economic growth.

"I'm on the Fed's side on this. Putting more reserves into the system this way is not inflationary," he said. "But in the end, it will depend how much of an appetite there is for this."

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