BONDS

Another bond-buying program seems likely as the Federal Reserve tries to boost the economy. But long term, it will lead to higher interest rates, inflation, and bond market turmoil, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

I think the Federal Reserve is setting up investors for a significant change in policy to be announced after Wednesday's meeting of the Fed's Open Market Committee. The new plan would resume the rapid growth of the Fed's balance sheet, and push it to $3 trillion sometime in 2013.

And that would make the big problem facing the Federal Reserve and the US economy even bigger. After expanding its balance sheet by buying what will soon be an additional $2 trillion in debt to help stave off the worst effects of the global financial crisis and then to support a stumbling US economy, how does the Fed shrink its balance sheet back to something like normal size without crashing the US and global economies?

The Federal Reserve's Operation Twist is scheduled to expire this month. That program to swap about $270 billion in short-term Treasury for longer-term, five- to seven-year debt to lower longer-term interest rates in order to support the recovery of the housing sector and to stimulate economic growth is almost certain to end with the year.

But Fed Chairman Ben Bernanke and company are also almost certain to replace Operation Twist with a new, more aggressive program of quantitative easing. The fallout from this will be new pressure on bonds that could eventually send investors fleeing—and those who aren't careful will get hurt in the rush.

A New Buying Binge
The Fed is clearly worried that the debate over the fiscal cliff alone—or worse, the actual expiration of all of the Bush tax cuts, the Social Security tax reduction, and extended unemployment benefits, plus the automatic budget cuts imposed by the debt-ceiling deal—could slow the economy and even send the US back into recession.

The new program, recent speeches by Federal Reserve governors and basic math argue, will be an out-and-out plan to buy five- to seven-year Treasuries. That would continue the thrust of Operation Twist but get around a big problem that the Fed now faces.

It has become increasingly hard for the Federal Reserve to sell its short-term holdings of Treasuries—and to buy medium-term debt to replace them—because the Fed has effectively sold most of its short-term holdings. Since September 2011, the Federal Reserve has replaced $667 billion of short-term Treasuries on its balance sheet with medium-term debt. The Fed just doesn't have any short-term Treasuries to sell.

The new program would require the further expansion of the Federal Reserve's already massive balance sheet, which stood at $2.85 trillion as of November 21. That $2.85 trillion level has been relatively stable since June 2011.

The new plan would change that. The number floating around Washington and Wall Street mentions Fed buying of about $45 billion in Treasuries a month. That would easily push the Fed's balance sheet to more than $3 trillion sometime in 2013. Amazingly enough, the Fed's balance sheet was at just about $1 trillion before the start of the current downturn.

The Federal Reserve's most recent plan for shrinking its balance sheet goes back to 2011. Then, the Fed projected that it might start selling off some of its holdings of Treasuries and other debt in mid-2015.

That, if you remember, is also when the Fed might begin raising the short-term interest rates that it directly controls. Recent announcements from the Federal Reserve's Open Market Committee have promised that the Fed would keep short-term rates at their current 0% to 0.25% level until at least the middle of 2015.

Logically, this plan made some sense: If the economy was strong enough by mid-2015 to withstand the downward pressure of higher short-term rates, it should also be strong enough to face some selling by the Federal Reserve of its medium-term debt portfolio.