Is the Fed’s Exit Strategy Legitimate?

In his congressional testimony last week, Fed chairman Ben Bernanke suggested that the Fed might seek to exit its current strategy of quantitative easing by allowing bonds to mature rather than by selling them.

As Hunter Lewis points out at the Circle Bastiat blog, this is sort of a more direct version of how Fed policy already works. At the moment, the Fed creates money out of thin air, which it then uses to purchase Treasury bonds, thereby financing the operations of the US government. The Treasury then pays interest on these bonds to the Fed, which uses those interest payments to purchase more Treasury bonds. (Technically, the Fed doesn’t buy its bonds from the Treasury directly, but from member banks; of course, Fed demand for the Treasuries is what motivates member banks to purchase them in the first place).

At the moment, the Fed earns interest from the Treasury on bonds which it has bought with the money it has just pulled ” out of thin air.” It then pays its expenses, including the growing cost of the new consumer finance agency created by Dodd Frank that was placed in the Fed so that its costs would not have to be included in the federal budget. Since the interest on the bonds is larger than the expenses, in the end the Fed sends money back to the Treasury.

We aren’t told exactly how much has been deducted at the Fed, but we do see the amount of money returning to the Treasury. It’s a circular flow designed to obscure what is happening, which is the government simply printing money to pay its bills.

If the Fed were to allow Treasury bonds to mature, it would require the Treasury to pay the principle to the Fed. Of course, the Fed would presumably use this principle payment to purchase more Treasury bonds.

In effect, the government has simply canceled its own debt.

Of course, even for those who think that this sounds like a legitimate arrangement, there is still the question of whether or not it’s possible. Investor Peter Schiff doesn’t think so. First of all, Schiff argues, it’s entirely possible that this option wouldn’t be sufficient to counteract inflation and/or asset bubbles, if those problems become pronounced enough.

As a result of its previous efforts during “Operation Twist” (which was conducted in order to push down long-term interest rates), the Fed has already swapped hundreds of billions of dollars of short-term securities for Treasury bonds with maturities of ten years or longer. Only a small portion of the Fed’s portfolio, then, becomes due at any given time. The average maturity of the entire portfolio is now over 10 years. There may well come a time when inflation or asset bubbles become so pronounced that aggressive withdrawal of stimulus is needed. Forceful action will only be possible through active selling, not simply by passive maturation.

Furthermore, Schiff argues, a Fed policy of allowing bonds to mature would require that the Treasury have the cash to actually meet those obligations–something that it largely accomplishes by rolling over its current debts.

However, either approach will be insufficient to tighten policy without a simultaneous cessation of buying of newly issued Treasury bonds. After all, to shrink the size of its balance sheet the Fed must stop adding to it…or at least add less than it is subtracting. Even if the Fed had the luxury of holding its bonds to maturity, such a stance would not prevent a collapse in the bond market. The Treasury does not have the cash needed to retire maturing bonds if the Fed stops rolling them over. As the government will have to sell the new bonds to other buyers, one way or another additional supply is going to hit the market.

On top of that, there’s another consideration: if the Treasuries have to be sold, either by the Fed as an attempt to contract the money supply or by the Treasury in an attempt to meet its maturing obligations to the Fed, someone is going to have to buy those bonds. If the Fed is currently driving demand for Treasuries, what happens when it doesn’t want them anymore? Will buyers be there?

The Federal government is projected to run trillion dollar deficits for years to come. To cover that gap, the Treasury will need to continuously sell new bonds. This need will persist regardless of the Fed’s policy priorities. For the last few years the Fed has been by far the biggest buyer of Treasuries, in recent times sucking up more than 60 percent of the total issuance. According to some reports, the Fed is expected to buy up to 90 percent of Treasuries in 2013. The only other significant buyers are foreign central banks (who buy for political reasons) and nimble hedge funds. Who does Bernanke expect will fill his shoes when he stops shopping?

To answer that question you must consider the economic environment that would compel the Fed to tighten in the first place. Presumably a period of accelerating economic growth, surging inflation, or rising interest rates would trigger asset sales. In such a situation, who in the world would want to buy low-yielding, long-term government paper while inflation is surging, the dollar is falling, and interest rates are rising? With the Fed on the sidelines, such an investment would be a guaranteed loser. Bernanke claims that the financial conditions will be soothed by an aggressive communications campaign that would let market participants know, in advance, precisely how the Fed intended to dispose of its assets. The cardinal rule in investing is that big players never telegraph their intentions. Fed “transparency” will simply mean that the hedge funds now making money by getting in front of the buying will be making even more money by getting in front of the selling!  There will be no cavalry of new buyers riding to the rescue.

This means that any attempt to tighten, no matter how passive, will result in a significant drop in the price of U.S. Treasuries and mortgage-backed securities. Not only would this inflict massive losses to the value of the Fed’s balance sheet but it would exert enormous upward pressure on interest and mortgage rates that the Fed will be unable to control.

The Fed, ostensibly, also has other tools. One of these is the rate that it pays to the banks which choose to park their cash at the Fed. By raising these rates, Fed proponents argue, the Fed could induce a de facto contraction of the money supply, as liquidity is removed from the markets and placed into interest accruing accounts.

In addition to his absurd “let them mature” gambit, Bernanke also announced other novel policy tools that will supposedly help him orchestrate a successful exit strategy, most notably raising the rates paid on funds held at the Federal Reserve. Such a move is expected to deter banks from lending into a surging economy or to invest in risky assets by enticing them to park cash at the Fed. But how high must these rates go, and how much would it cost the Fed (in reality U.S. taxpayers) to do this effectively? Given how high I believe inflation will become, these payments could be truly staggering. The net result will be a substitution of large operating losses for large portfolio losses (which would have come from bond sales).

To back up a few steps, I think those who align more with today’s mainstream economic theory regard those who oppose Fed intervention in the financial sector as more or less unsophisticated. And, to some extent, some of the arguments against the Fed can be very unsophisticated. For instance, those who cry “inflation” in response to Fed policy need to realize that proponents of that policy believe that they have that problem figured out. By selling off assets once the economy strengthens, they believe, the Fed can counteract any potential inflation and the economy will take it from there.

This, as Lewis and Schiff argue here, rests on the notion that the Fed is going to be able to sell those assets, and that it’s going to be able to do so in a cost-effective manner. But it seems that that conclusion, upon further inspection, is far from foregone.

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