Tag: quantitative easing

Is the Federal Reserve Heading Towards Insolvency?

A recent statement from the Shadow Financial Regulatory Committee, points out that both rounds of quantitative easing by the Federal Reserve have dramatically altered the maturity structure of the Fed’s balance sheet.  Normally the Fed conducts monetary policy using short-term Treasury bills, which allows the Fed to avoid most interest rate risk.  In loading up its balance sheet with long-dated Treasuries and mortgage-backed securities, the Fed has exposed itself to significant interest rate risk.

Recall that the yield, or interest rate, on a long term asset is inversely related to its price.  So if you’re holding a mortgage that yields 5% and rates go up to 6%, then the value of that mortgage falls below par.  The same holds for Treasury securities.  I think  it is a safe assumption that rates will be higher at some point in the future.  When they finally do rise, and if the Fed still maintains a large balance sheet of long-dated assets, those assets will suffer losses.

Of course the Fed is not subject to mark-to-market rules and can avoid admitting losses by holding these assets to maturity.  But if the Fed, at some point in the future, wants to fight inflation, the most obvious way of doing so would be to sell off assets from its balance sheet.  It is hard to see the Fed engaging in substantial open-market operations without using its long-dated assets.  But if it is to sell these assets, it will have to do so at a loss (once again, because of higher rates).

Now the Fed claims to have other avenues by which to tighten, besides open-market operations.  For instance, it can raise the interest rate on excess reserves.  But then this would further erode the value of assets on its balance sheet.  Not to mention that they have to find the money somewhere to pay these higher rates on reserves.

Ultimately the Fed can continue to pay its bills, not out of earnings from its balance sheet, but by electronically crediting the accounts of its vendors and employees, but that would also be inflationary.  The real danger, again pointed out by the Shadow Committee, is that the Fed may avoid raising rates in order to minimize the losses embedded in its balance sheet.  One of the very real dangers from QE1 and QE2 is that the Fed has exposed itself to potential losses that are correlated with any efforts to fight inflation, raising serious questions as to its willingness to fight inflation.

Currency Wars Also Have Unintended Consequences and Collateral Damage

The Fed’s planned purchases of $600 billion of long-term Treasury bonds were targeted for domestic problems, but are having international consequences. The expansion of the Fed’s balance sheet drives down the foreign-exchange value of the U.S. dollar, and (same thing) forces other currencies to appreciate in value.

Emerging markets with high short-term interest rates will attract “hot money” flows. These flows are not stable sources of funding, and disrupt the small capital markets in these countries. Long-term, the appreciation of their currencies harms their competitiveness in global goods’ markets.

Brazil has already imposed capital controls and other emerging markets may follow. The Chinese in particular have reacted sharply.  According to a Reuters dispatch, Xia Bin, adviser to China’s central bank, said another financial crisis is “inevitable.” He added that China will act in its own interests.

In short, the Fed’s actions have undone whatever good came out of the G20 meetings. Any hope for cooperation on currency values and financial stability is out the window. There are potential spillovers in other areas of global cooperation.

Currency wars, like other wars, have unintended consequences and collateral damage.  Some countries will predictably react by imposing capital controls.  Moves to curb imports can follow. Monetary protectionism leads to trade protectionism.

However it might like matters to be, the Fed cannot simply act domestically.  It has reached the useful limits of further easing.

Bernanke’s Twist on Price Stability

While it’s been obvious for years, Bernanke showed his rationale for more easing in today’s Washington Post.  He believes we are in danger of too little inflation.  While common sense might imply that price stability means neither inflation nor deflation, in Bernanke’s book, anything below the Fed’s target of 2 percent is bad.

First of all, there really needs to be a public debate over the Fed’s 2% target.  After all, a 2% rate of inflation over, say, 30 years erodes almost half of one’s wealth.  How that can seriously be viewed as “price stability” is beyond me.  While a 2% rate of inflation is not going to bring the economy to a halt, it is still a massive theft of wealth over the long haul.

Bernanke has also expressed the fear that “low and falling” inflation could lead to deflation, which would raise the real value of debt, which could lead to additional defaults.  But what Bernanke doesn’t seem to get is that inflation isn’t falling. Let’s go to the data.

The graph below is simply the consumer price index (CPI) over the last year.  Does it appear to be falling?  Of course not.  In fact, the trend is one that is rising.

Now CPI includes lots of things, some of which are temporary trends.  The Fed has a nasty habit of excluding those items it doesn’t like.  But let’s take a look at something that matter to the typical family:  food.

In the next chart, we can see that the trend in food costs over the last year has been upward, not down.  Contrary to Mr. Bernanke’s worries, most families worry about putting food on the table, which has been getting more expensive, not less.

Another trend worth examining is the cost to producers, best measured via the producer price index (PPI).  As one can see from the next chart, that has been heading up as well.

The point to all of this is that we aren’t seeing this deflation that Bernanke constantly worries about and we aren’t headed in that direction either.  And the worse part is that we’ve been here before.  In the earlier part of the decade, then–Fed Governor Bernanke urged Greenspan to fight any chance of deflation by cutting rates to what were then all-time lows.  The result was a housing bubble.  Thanks again Ben. 

Now this might all be worth the cost if it reduced unemployment.  But it won’t.  The traditional way Fed policy brings down unemployment is by increasing bank lending, but banks are already sitting on a trillion in reserves.  Inflation, in and of itself, does not create jobs.