Fed Sterilization Program: Walking The Tight Rope

Yesterday the Fed leaked news of a new Quantitative Easing program they are considering.  It is called "sterilization."  I know, I know, another weird term to keep everyone confused.

I posted an excellent video interview yesterday with Jim Grant discussing the program, but I'll explain it here in more easy to understand terms.

The Fed will print money to purchase longer dated bonds (such as 30 year treasury bonds or 30 year mortgage bonds).  The Fed then goes into the financial system and removes shorter term bonds, placing them on their balance sheet.  The result is a net - net no increase in total money supply available in the system, which helps guard against inflation.  The Wall Street journal posted an excellent graphic this morning showing this process:

The goal is to keep long term rates down (help homeowners refinance and let our government continue recklessly spending) without any increases in food or energy prices.

The Fed believes that they someone have some sort of magic wand over the economy.  Up until know, because the markets have behaved orderly, they have created the illusion that this is correct.

If we get either a major sell off in the stock market (say due to a Greece default that I will be discussing in great detail this week) or a spike in the price of energy (Iran) or food, then their aura of invincibility will instantly fade.

Everything is magnified because we are in an election year.  The Fed must walk a tight rope to keep their master (Obama) happy on the throne but not push too hard and create an inflation shock.

Up until now (it has appeared) they have been able to walk this rope with ease.  This will change with the first gust of wind brought on by the markets.