"One thing I've been wondering is how long will it take before the banking system, which is getting free money from the Fed, starts to turn it back on the economy. i.e. - says, 'There are no good investment opportunities - let's take this $40 billion from the Fed and short the market.'"
It may have already happened. The high water mark for the S&P 500 index was 1465.77 on Sep 14, the after the FOMC announced QE3 compared with last price at around 1413. Counterintuitive as this may sound, market participants may finally be getting hip to the idea that QUANTITATIVE EASING is more deflationary than inflationary.
The Treasury issues debt to cover the deficit and then the Fed buys most of the long term debt back along with $40 billion per month of mortgage backed securities. In recent years the Fed has been earning about $80 billion in interest income which it then remits back to the Treasury and now with the Fed's balance sheet swelling to around $2 Trillion that interest income will probably be more like $100 to $110 billion for FY 12013. Note the circular flow of interest payments. This is debt that the government owes itself and there is no good reason why it should apply to debt ceiling.
After all, what difference is there between the Treasury issuing debt and the fed buy it back, vs. the Treasury not issuing that debt in the first place?
Is there any good reason why the Treasury and Federal Reserve couldn’t simply wave a magic wand over this $1.6 Trillion of Treasury debt owned by the Fed and declare it null and void?
That bold action would reduce the outstanding debt to $14.4 Trillion which is well below the current statutory debt ceiling of $16.394 Trillion.
Instead of driving off the fiscal cliff like Thelma and Louise, the Treasury and Fed could give Congress the means to slam on the breaks. This would buy policy makers another year or so of valuable breathing space to formulate sensible fiscal policy for economic growth rather than causing a self inflicted wound on the economy and millions of American workers and businesses.
Mr. Bernanke, if you seek transparency and accountability for the Fed…. If you seek prosperity for American citizens then come to Congress and tell our law makers that the Treasury debt held by the Fed should not apply to the debt ceiling. Mr. Bernanke TEAR UP THIS DEBT!
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