UBS: The Federal Reserve Could Accidentally Raise Rates In Its Efforts To Lower Rates

ben bernanke fed failBen Bernanke

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UBS senior economist Drew Matus was on Bloomberg TV this morning previewing Wednesday’s FOMC meeting. Many of the major investment banks are expecting the announcement of significant policy action, while UBS is not.However, Matus said if the Fed does decide to announce additional stimulus on Wednesday, the focus will be on three main questions:

Let’s say everyone else is right and we’re wrong — they do some sort of Operation Twist. The two key factors are going to be: how long is the Twist program for? Our best guess is that if we’re wrong, they are going to extend it for a very small period of time — maybe three months. 

And how big is it? And finally, how do they finance it? The Fed has been selling short term securities, but they’re effectively running out of short term securities to sell.

That third question is key, because lowering long-term interest rates through an Operation Twist requires selling short-term securities while selling long-term securities.

Does that mean they go into the reverse repo market and push out securities — lend securities out and pull cash in — in order to finance it? If they do, they actually raise the risk of raising rates by accident.

Matus said, however, that now is not the time for the Fed to ease, especially given that the election results in Greece have not affected the robust deman for US Treasuries, which means rates are staying anchored:

At this point, we think the Fed will try to use Greece to its advantage. By that I mean that if the Fed doesn’t go out and buy securities tomorrow, it’s not like long-end yields are going to suddenly skyrocket.

Greece is still out there weighing on the markets. This is the time for the Fed to pull back, get out, and actually break the addiction the market has to easing cycles.

According to Matus, this market addiction to easing has had way too much influence on the Fed’s monetary policy decisions, and it could be a key driver behind a potential easing announcement out of Wednesday’s FOMC meeting:

The biggest risk to our outlook that the Fed doesn’t do anything is simply that this Fed has been very unwilling to disappoint market participants. Of course, the danger in that though is that if you let market participants decide what Fed policy is going to be, there’s never going to be rate increase ever — until you get inflation at a point where it’s out of control.

SEE ALSO: BofA: The Spanish Bond Market Will Collapse Without ECB Intervention

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