When Sterilization is Not a Form of Birth Control

I received a flurry of inquires the other day when Ben Bernanke mention the word “sterilization” in his recent congressional testimony. And he wasn’t giving advice to the country’s wayward teenaged girls, either.

Sterilization refers to a specific style of monetary policy. Sterilized policies seek to manipulate the money markets without changing the overall money supply. The Fed implemented just such a strategy last summer when they initiated their “twist” policy. This involved buying 10, 20, and 30 Treasury bonds and selling short an equal amount of short term Treasury bills.

The goal here was to force investors out of the safety of Treasury bonds and into riskier assets like stocks, commodities, and real estate. Given the market action since then, I’d say that he at least partially succeeded.

Dollar for dollar there is no change in the Fed’s balance sheet when sterilized actions are undertaken, although there is a huge increase in the risk profile of their portfolio. A private institution would be insane to do this at this stage of the economic cycle, as the risk of capital loss is great. But governments are exempt from mark to market rules and can carry this paper at cost or par, whatever they want. That’s why we have a central bank.

The Fed is now running up against a unique problem. The twist program is so large that it is literally running out of short term securities to sell. When this happens, they may well resort to 28 day repurchase agreements instead, which are essentially sales of short term paper out the back door. This is what Uncle Ben was attempting to explain to our congressional leaders, which I’m sure went straight over their heads.

The really interesting thing here is why Bernanke is suddenly interested in sterilization? These are the types of polices you pursue to head off inflation. With wages continuing to fall it is difficult to see why this should be an issue.

Maybe he’s looking at the price of gasoline or the stock market instead, which have recently been going through the roof. Perhaps he’s looking several years down the road. The great challenge for the Federal Reserve from here will be unwinding their massive $2.8 trillion balance sheet it build up during the Great Recession without triggering runaway price increases.

If Bernanke does have an inkling of coming inflation it could have huge implications for a security dear to my heart, the (TBT), a leveraged ETF that benefits from falling Treasury bond prices. Although it has been flat lining for the last four months, you better keep this one on your short list. It’s just a matter of time before we get an upside breakout.

For an excellent explanation of the history of monetary sterilization, please click here.

 

No, Not This One

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