Fed Open Market Operations And You

By Gregory S. Davis | March 23, 2009 AAA

The Federal Reserve's decision to pump dollars into the U.S. economy by purchasing $300 billion in long-term treasuries over the next six months is an example of an expansionary type of monetary policy. Let's take a closer look at concerns the Fed action raises and how individual investors can use a variety of mixed-maturity fixed income ETFs to prepare for possible future repercussions.

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Monetary Policy Basics
In contrast to fiscal policy, which focuses heavily on tax revenues to meet economic challenges like inflation, monetary policy focuses on affecting the money supply by adding or removing money from circulation. In theory, these changes in monetary policy ultimately affect the future direction of interest rates. Making more money available through an action such as buying long-term treasuries can be categorized as an expansionary policy. The action taken by the Fed is intended to help the U.S. speed its recovery by making capital more readily available in the marketplace. (To learn more about these concepts, be sure to check out the Monetary Policy section of our Federal Reserve Tutorial.)

Fixed Income ETFs Year to Date 3-Year Return
iShares Lehman 20+ Year Treasury Bond
(NYSE:TLT)
-15.27% 8.99%
iShares Lehman 7-10 Year Treasury Bond
(NYSE:IEF)
-0.80% 10.24%
Vanguard Short-Term Bond
(NYSE:BSV)
-2.94% N/A
iShares Barclays TIPS Bond Fund
(NYSE:TIP)
-1.05% 3.69%
Data as of March 19, 2009


Expansionary Policy Threats
Expansionary policy does not come without its own set of risks including a lag effect, the time it takes before the changes have a real effect on the economy and inflation. Paul Volcker, the former Federal Reserve chairman and the current first chair of President Obama's Economic Recovery Advisory Board, knows a lot about inflation. Volcker was head of the Fed when inflation in the U.S. rose as high as 13.5% and the federal funds rate peaked at 20% in the early 1980s. He is credited for helping to bring the inflation rate back down to the single digits during his tenure. (See our Inflation Tutorial for further reading on the causes and effects of inflation.)

ETF Strategy To Combat Future Inflation
In a future environment where we may witness interest rates reversing their current downward trajectory, investors should keep in mind that investments with long-term maturities like the iShares Lehman 20+ Year Treasury Bond ETF tend to underperform securities with shorter maturities like the Vanguard Short-Term Bond ETF. Two other options to consider are taking the middle road with the iShares Lehman 7-10 Year Treasury Bond ETF or focusing less on interest rates and more on the movement of the Consumer Price Index by opting for the iShares Barclays TIPS Bond Fund ETF.

Where Are We Today?
The Federal Reserve issued a press release on March 18 stating its intention to keep the federal funds rate at 0% to 0.25% for an extended time. Given this news, investors have time to develop their investment strategy for hedging against the future rise in interest rates. Since neither investing in long-term nor short-term securities can guarantee positive returns, it's best to take a diversified approach when building any investment portfolio.

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