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Federal Reserve's 'Sterilized' QE3 May Get Messy

NEW YORK ( TheStreet) -- Reports that the Federal Reserve is toying with the idea of a "sterilized" U.S. Treasury bond trade as a way to push liquidity into the markets without igniting inflation sounds like a great deal.

Which, as it turns out, is exactly the point: Flood the economy with money without sounding inflationary alarm and causing equity investors to flee the U.S. markets in droves.

Under the proposed third quantitative easing plan (QE3), first reported by The Wall Street Journal, the Fed will buy mortgage-backed securities (MBS) and longer-dated U.S. Treasury bonds. That would give big investors already loaded up with Treasuries additional buying power, pushing down long-term yields and freeing up capital.

The Federal Reserve will pay for the program by doing what central banks do best -- printing money. But turning up the Fed printing presses is the first signal to the equity markets that asset-destroying inflation can't be far behind.

Any stimulus would be canceled out by a stock market swoon.

In order to dance around the specter of inflation, the Fed would then "sterilize" the trade by locking up the bonds with the buyers for a short period of a month or less. That would, in theory, damn up the liquidity at the source and keep from it flooding into the broader economy where it would push up prices.

The sterilization part of the Fed's trade idea is known as a reverse repurchase agreement, or reverse repo, and its entire purpose is to convince the stock market that inflation is off the table, said Arvind Krishnamurthy, professor of finance at the Kellogg School of Management at Northwestern University.

"From [the Fed's] viewpoint, the market drives inflation expectations, so the Fed cares what the market thinks," Krishnamurthy said. "The Fed is trying to do a large asset purchase and wants to convince the market it does not want to inflate."

Goldman Sachs economist Zach Pandi also agreed that the sterilized QE3 is all about the perceptions of the stock and commodities markets.

"If a subset of the population holds these beliefs -- wrongly or not -- unsterilized QE could affect inflation expectations and possibly commodity prices beyond its impact on the growth outlook," Pandi said in a note cited in Thursday's Journal. "Sterilizing may therefore be a low-cost way to avoid, or at least to hedge against, possible negative side effects of further easing action."
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