The FED has changed enormously in the past nine months. Between last September and now, Reserve Bank credit has gone up 135 percent. Will the FED change back to what it used to be? Does it have a workable exit strategy? Very, very doubtful.
The FED used to manage monetary policy, and that was about all. Today it’s engaged in fiscal actions that have to do with the government’s debts. The two main ones are that it is buying $300 billion of U.S. Treasuries and it is buying $1.25 trillion of mortgage-backed and agency debts.
The FED traditionally bought U.S. debt, but never in such volume. The government deficits are so large that the FED will probably eventually announce one or more new programs to buy U.S. debt. At a minimum, these deficits ensure that the FED will not be soon selling what it now is in the midst of buying. No exit here.
The FED never bought mortgage-backed securities as part of its permanent portfolio. Now it is. It is buying these securities from housing-related government-sponsored enterprises (GSEs) such as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.
Fannie Mae and Freddie Mac are now wards of the state. The FED’s support of them and the housing markets is a fiscal action. The FED is more deeply engaged with the government than ever before.
The FED is buying long-term bonds from these agencies. It claims that interest-rate risk is not an issue:
"The market valuation of agency MBS can fluctuate over time based on the interest rate environment; however, the Federal Reserve’s exposure to interest rate risk is mitigated by the conservative, buy and hold investment strategy of the agency MBS purchase program."
If the FED holds these securities to maturity (which is 15 to 30 years hence), it will not be selling these bonds so as to disengage from the government and so as to reduce its credits. It will then have to find other ways to defuse the inflationary potential of that credit such as paying higher interest on reserves. No matter what it does, it will not be getting back to what it used to be anytime soon. The FED’s engagement with government is far from temporary. No exit here.
(If the FED, contrary to what it has stated, intends to sell these securities before they mature, then it certainly faces interest-rate risk. Even if it does not sell these securities, it faces interest-rate risk (contrary to what it says) because the value of the bonds will sink if interest rates rise.)
In the past nine months, the U.S. Treasury made very large deposits at the FED. These restrained the growth in the monetary base, other things equal. But they also provided the Treasury a degree of control over the FED that is new. This Supplementary Financing Program also engaged the FED with the government.
Treasury deposits have been run down from a peak $620 billion last November to $226 billion now. The monetary base rose over $235 billion as a result.
The more that the FED becomes engaged in the government’s fiscal policies and debt management, and the more that the FED depends on Treasury financing, the greater the risk that the FED is unable to disengage from the government. The greater becomes the risk that it will continue and expand its credit activities at the government’s behest or pressure. The greater become the risks of high inflation or even hyperinflation. The latter can occur through a loss in confidence among Americans or other holders of dollar denominated bonds that the FED has the situation under control.
Or suppose that another recession starts up, not that this one has yet ended, or that this one has a feeble recovery followed by a new dip. The FED would be unable to decrease its balance sheet. Government deficits would rise, and the FED would monetize some of the debt. No exit here.
So far, the government and the FED have not provided a workable exit program for the FED. Such a program would probably require the Congress to take the FED off the hook by absorbing some of its loans. This is not impossible but it’s improbable in the visible future. The FED is supporting the GSEs for Congress and supporting the Treasury’s financing of deficits made in Congress. The Congress can play at criticizing the FED all day long, but the FED is supporting the fiscal policies of the Congress; and it will probably be doing that for a long time to come. Congress prefers that to having the problems on its books.
No exit means a persistently higher risk of inflation and worse.
The FED has created a huge monetary base with long-run potential to be loaned into the economy. This is a situation that it cannot allow to happen without disastrous consequences. Bank reserves are a large component of that monetary base. To sterilize (or neutralize their lending potential), the FED can pay interest on reserves. There is no free lunch here for the FED. It could be doing this for many years to come, during which time it becomes harder for it to handle its monetary actions. Paying interest on bank reserves of $800 billion at 3 percent, say, costs $24 billion a year. The FED ordinarily turns its earnings over to the Treasury. This means that the FED’s earnings will be $24 billion lower (it going to the banks to sterilize their reserves) and the revenues to the government are $24 billion lower.
Follow the money: The FED buys mortgage-backed securities. The government ends up giving up $24 billion annually to the FED who pays it to the banks. The present value of this is a very substantial amount of wealth transferred from taxpayers to the banks. Bank stocks will go up in price when the FED starts paying higher interest on reserves, if not sooner.
When Congress realizes what’s going on, there is bound to be pressure placed on the FED.
The FED changed in several other major ways in the past nine months. It took on from banks what most people think are poor credits via its term auction credit program. They add up to $274 billion. These appear to be frozen on the FED’s balance sheet. There is no apparent exit there either.
It extended substantial credit to AIG, and that too is going nowhere fast.
Its central bank swaps and commercial paper credits have declined quite a lot. They are still a rather high $224 billion in total. The exit here is real but slow. Another recession would halt and reverse it.
The FED changed its basic nature when it chose to make loans to specific entities, rather than providing general credit to the banking system. It became a fixed income fund. It replaced the capital market. It allocated credit. This too is a kind of fiscal function practiced by governments that wish to control the economy’s financing.
All told, the FED has changed from a largely monetary institution to a monetary and fiscal institution that is linked to the Congress and the Treasury, i.e., to the government. The FED was never completely independent, of course. It was a private-public institution, but one whose activities were mostly monetary (apart from the period of the Accord). Now its activities are more in the public domain, more fiscal, and more governmental. They are more under the influence of government. That has historically been a situation that created higher inflation and sometimes hyperinflation.
To my mind, this means that the FED faces very serious problems. The government deficits and the government’s love affair with the GSEs ensure this.
But the FED’s problems are our problems, that is, the problems of anyone who holds dollars or dollar-denominated assets. All the risks that the FED faces load onto the value of the dollar.
The government is already committed to huge deficits. In several places above, I mentioned the risk of another recession or a further downturn in this one. If that should happen, even if it happens several years from now, the government-FED system will be placed under an impossible strain. That too suggests no exit, because the FED will pump more money rather than allow that doomsday event to occur. However, doomsday will eventually overtake the government and the FED anyway. The dollar amounts of the fiscal and monetary swings are simply getting too large compared to the production in the economy and the tax base. Doomsday may possibly be resolved, when it stares America in the face, by a sharp cutback in government’s size and by a return to a trustworthy currency.
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.