Best of the Week
Most Popular
1. US Housing Market Real Estate Crash The Next Shoe To Drop – Part II - Chris_Vermeulen
2.The Coronavirus Greatest Economic Depression in History? - Nadeem_Walayat
3.US Real Estate Housing Market Crash Is The Next Shoe To Drop - Chris_Vermeulen
4.Coronavirus Stock Market Trend Implications and AI Mega-trend Stocks Buying Levels - Nadeem_Walayat
5. Are Coronavirus Death Statistics Exaggerated? Worse than Seasonal Flu or Not?- Nadeem_Walayat
6.Coronavirus Stock Market Trend Implications, Global Recession and AI Stocks Buying Levels - Nadeem_Walayat
7.US Fourth Turning Accelerating Towards Debt Climax - James_Quinn
8.Dow Stock Market Trend Analysis and Forecast - Nadeem_Walayat
9.Britain's FAKE Coronavirus Death Statistics Exposed - Nadeem_Walayat
10.Commodity Markets Crash Catastrophe Charts - Rambus_Chartology
Last 7 days
Will You Make Money in the New Silver Bull Market ? - 13th Aug 20
Hyper-Deflation Capital Destruction And Gold & Silver - 13th Aug 20
Stock Market Correction Approaching - 13th Aug 20
Silver Took the Stairs to $21 in 2008, Took Escalator to $29 2010. Is Silver on Elevator to 120th floor today? - 13th Aug 20
President Trump Signs Additional COVID Relief – What To Expect from the Markets - 13th Aug 20
Has Gold's Upward Drive Come to an End? - 13th Aug 20
YouTuber Ads Revenue & How to Start a Career on YouTube - 13th Aug 20
Silver Notches Best Month Since 1979 - 12th Aug 20
Silver Shorts Get Squeezed Hard… What’s Next? - 12th Aug 20
A Tale of Two Precious Metal Bulls - 12th Aug 20
Stock Market Melt-Up Continues While Precious Metals Warn of Risks - 12th Aug 20
How Does the Gold Fit the Corona World? - 12th Aug 20
3 (free) ways to ride next big wave in EURUSD, USDJPY, gold, silver and more - 12th Aug 20
A Simple Way to Preserve Your Wealth Amid Uncertainty - 11th Aug 20
Precious Metals Complex Impulse Move : Where Is next Resistance? - 11th Aug 20
Gold Miners Junior Stcks Buying Spree - 11th Aug 20
Has the Fed Let the Inflation Genie Out of the Bottle? - 10th Aug 20
The Strange Food Trend That’s Making Investors Rich - 10th Aug 20
Supply & Demand For Money – The End of Inflation? - 10th Aug 20
Revisiting Our Silver and Gold Predictions – Get Ready For Higher Prices - 10th Aug 20
Storm Clouds Are Gathering for a Major Stock and Commodity Markets Downturn - 10th Aug 20
A 90-Year-Old Stock Market Investment Insight That's Relevant in 2020 - 10th Aug 20
Debt and Dollar Collapse Leading to Potential Stock Market Melt-Up, - 10th Aug 20
Coronavirus: UK Parents Demand ALL Schools OPEN September, 7 Million Children Abandoned by Teachers - 9th Aug 20
Computer GPU Fans Not Spinning Quick FIX - Sticky Fans Solution - 9th Aug 20
Find the Best Speech Converter for You - 9th Aug 20
Silver Bull Market Update - 7th Aug 20
This Inflation-Adjusted Silver Chart Tells An Interesting Story - 7th Aug 20
The Great American Housing Boom Has Begun - 7th Aug 20
Know About Lotteries With The Best Odds Of Winning - 7th Aug 20
Could Gold Price Reach $7,000 by 2030? - 6th Aug 20
Bananas for All! Keep Dancing… FOMC - 6th Aug 20
How to Do Bets During This Time - 6th Aug 20
How to develop your stock trading strategy - 6th Aug 20
Stock Investors What to do if Trump Bans TikTok - 5th Aug 20
Gold Trifecta of Key Signals for Gold Mining Stocks - 5th Aug 20
Stock Market Uptrend Continues? - 4th Aug 20
The Dimensions of Covid-19: The Hong Kong Flu Redux - 4th Aug 20
High Yield Junk Bonds Are Hot Again -- Despite Warning Signs - 4th Aug 20
Gold Stocks Autumn Rally - 4th Aug 20
“Government Sachs” Is Worried About the Federal Reserve Note - 4th Aug 20
Gold Miners Still Pushing That Cart of Rocks Up Hill - 4th Aug 20
UK Government to Cancel Christmas - Crazy Covid Eid 2020! - 4th Aug 20
Covid-19 Exposes NHS Institutional Racism Against Black and Asian Staff and Patients - 4th Aug 20
How Sony Is Fueling the Computer Vision Boom - 3rd Aug 20
Computer Gaming System Rig Top Tips For 6 Years Future Proofing Build Spec - 3rd Aug 20
Cornwwall Bude Caravan Park Holidays 2020 - Look Inside Holiday Resort Caravan - 3rd Aug 20
UK Caravan Park Holidays 2020 Review - Hoseasons Cayton Bay North East England - 3rd Aug 20
Best Travel Bags for 2020 Summer Holidays , Back Sling packs, water proof, money belt and tactical - 3rd Aug 20
Precious Metals Warn Of Increased Volatility Ahead - 2nd Aug 20
The Key USDX Sign for Gold and Silver - 2nd Aug 20
Corona Crisis Will Have Lasting Impact on Gold Market - 2nd Aug 20
Gold & Silver: Two Pictures - 1st Aug 20
The Bullish Case for Stocks Isn't Over Yet - 1st Aug 20
Is Gold Price Action Warning Of Imminent Monetary Collapse - Part 2? - 1st Aug 20
Will America Accept the World's Worst Pandemic Response Government - 1st Aug 20
Stock Market Technical Patterns, Future Expectations and More – Part II - 1st Aug 20
Trump White House Accelerating Toward a US Dollar Crisis - 31st Jul 20
Why US Commercial Real Estate is Set to Get Slammed - 31st Jul 20
Gold Price Blows Through Upside Resistance - The Chase Is On - 31st Jul 20
Is Crude Oil Price Setting Up for a Waterfall Decline? - 31st Jul 20
Stock Market Technical Patterns, Future Expectations and More - 30th Jul 20
Why Big Money Is Already Pouring Into Edge Computing Tech Stocks - 30th Jul 20
Economic and Geopolitical Worries Fuel Gold’s Rally - 30th Jul 20
How to Finance an Investment Property - 30th Jul 20
I Hate Banks - Including Goldman Sachs - 29th Jul 20
NASDAQ Stock Market Double Top & Price Channels Suggest Pending Price Correction - 29th Jul 20
Silver Price Surge Leaves Naysayers in the Dust - 29th Jul 20
UK Supermarket Covid-19 Shop - Few Masks, Lack of Social Distancing (Tesco) - 29th Jul 20
Budgie Clipped Wings, How Long Before it Can Fly Again? - 29th Jul 20
How To Take Advantage Of Tesla's 400% Stock Surge - 29th Jul 20
Gold Makes Record High and Targets $6,000 in New Bull Cycle - 28th Jul 20
Gold Strong Signal For A Secular Bull Market - 28th Jul 20
Anatomy of a Gold and Silver Precious Metals Bull Market - 28th Jul 20
Shopify Is Seizing an $80 Billion Pot of Gold - 28th Jul 20
Stock Market Minor Correction Underway - 28th Jul 20
Why College Is Never Coming Back - 27th Jul 20
Stocks Disconnect from Economy, Gold Responds - 27th Jul 20
Silver Begins Big Upside Rally Attempt - 27th Jul 20
The Gold and Silver Markets Have Changed… What About You? - 27th Jul 20
Google, Apple And Amazon Are Leading A $30 Trillion Assault On Wall Street - 27th Jul 20
This Stock Market Indicator Reaches "Lowest Level in Nearly 20 Years" - 26th Jul 20
New Wave of Economic Stimulus Lifts Gold Price - 26th Jul 20
Stock Market Slow Grind Higher Above the Early June Stock Highs - 26th Jul 20
How High Will Silver Go? - 25th Jul 20
If You Own Gold, Look Out Below - 25th Jul 20
Crude Oil and Energy Sets Up Near Major Resistance – Breakdown Pending - 25th Jul 20
FREE Access to Premium Market Forecasts by Elliott Wave International - 25th Jul 20
The Promise of Silver as August Approaches: Accumulation and Conversation - 25th Jul 20
The Silver Bull Gateway is at Hand - 24th Jul 20
The Prospects of S&P 500 Above the Early June Highs - 24th Jul 20
How Silver Could Surpass Its All-Time High - 24th Jul 20

Market Oracle FREE Newsletter

How to Get Rich Investing in Stocks by Riding the Electron Wave

The Fed's Quasi-Fiscal Policies

Interest-Rates / Quantitative Easing Feb 09, 2012 - 11:25 AM GMT

By: David_Howden


Best Financial Markets Analysis ArticleThe policies that the Fed embarked on in late 2007 are a sharp departure from the old way of performing monetary policy. In fact, it is difficult to state that the Fed is any longer in the business of traditional monetary policy — understood in the United States as aiming for low inflation and smoothed output volatility. A new breed of monetary policies better referred to as "quasi-fiscal" policies has become the norm.

The Fed's policies have a fiscal flair to them for two reasons.

First, no longer are output and inflation the primary concerns. The Fed has framed any reference to inflation over the past four years in the context of either:

  1. the low levels of price inflation erasing inflationary fears from pursuing unorthodox monetary policies, or
  2. the threat of deflation, thus creating the "need" for monetary expansion to ward off its ill effects.

Inflation has not been a direct concern in the sense that the Fed's role is to control it. Instead, it has been viewed as a constraint on Fed policies to pursue other ends.

Concerns about maintaining output have likewise taken a backseat. Monetary economists (Fed officials included) conventionally viewed monetary policy as a tool to minimize the output gap. During recessionary periods, just the right dose of monetary expansion should tempt employers to increase production and hire workers. The attention now, however, is on keeping banks capitalized through monetary expansion. By not allowing the bad debts on banks' balance sheets to bring them to insolvency, the Fed is hoping to stave off a contagious banking crisis. The Fed is seemingly less directly concerned with maintaining output, and more with keeping banks afloat (which, admittedly, officials think will translate into employment).

The second reason that the Fed has been taking on decidedly fiscal activities is that its policies are directly affecting its own finances. Traditional monetary policy left the Fed's balance sheet intact. Until this recession, the textbook explanation of how the Fed alters the money supply held true: it bought or sold Treasury bills, and the money supply correspondingly increased or decreased. By purchasing assets of lesser quality over the recession, the Fed has endangered its own balance sheet in the name of strengthening those of the preferred members of the banking system.

Philipp Bagus and I were among a small chorus of economists who noticed the fiscal aspect to these new monetary policies when they started. Several years ago we pointed to the dangers that such policies could breed.[1] In particular, we focused on the compromised role of money as a store of value as the quality of the money-supply-backing assets (the Fed's assets) diminished. We viewed inflation, in other words, as a looming threat beyond the level normally targeted by the Fed. We gave two reasons.

First, as the Fed bought low-quality assets to strengthen the banking system's balance sheet, it has increased the base money supply by almost 2 trillion dollars (or 250 percent). The Fed was not immediately concerned, as inflationary pressures seemed subdued. Besides, in the future the position could be unwound — the Fed could just sell the assets it purchased (mortgage-backed securities and GSE debt) back to the banking sector, draining the cash from banks' reserves in the process. In theory, inflation would be a nonissue.

The problem that few considered was simple: what would happen if the Fed's new assets lost value before they were sold back to the banking system? A qualitative mismatch was made. The Fed bought assets of uncertain value and paid for them with assets fixed at par value by definition (reserves). Any loss of value in the Fed's new assets would translate into new money that the Fed could not purchase back from the banking system. In other words, inflationary pressures will appear if the Fed realizes a loss on its assets (which it has not had to do, as they remain largely unsold). Alternatively, to bring expectations into the picture, inflationary pressures can build today on the expectation that in the future the Fed will have to realize a loss on its assets.

The second inflationary threat comes in the form of an unusual question. What happens if the Fed goes bankrupt? While an institution granted monopoly rights over the issue of money is a strange candidate for insolvency, there is precedent, though mainly in cases with a currency mismatch between the central bank's assets and liabilities.[2] Luckily for Ben Bernanke and the gang, no such mismatch plagues the Fed. Nor does the Fed have many inflation-indexed liabilities, another holding that could endanger its solvency. Just to be safe, the Fed changed its accounting rules about a year ago to ensure that the bookkeepers would not have to worry about troublesome insolvencies.

Still, is the Fed safe from declaring itself insolvent? Not as long as it holds weak assets on its books.

The Fed currently has about $800 billion worth of mortgage-backed securities included in its assets. Add to that $100 billion of federal-agency debt securities, not all of which are guaranteed by the federal government. Include roughly $35 billion worth of AIG assets still on the books, and the Fed has a sizable holding of inarguably low-quality assets. (With the downgrade of the federal government last year, some might say that the Treasuries are not much better.) If the value of these questionable assets decreases, there is no automatic adjustment for its liabilities to follow suit. Cash sells at par, everywhere and always. The Fed’s liabilities will hold their par value, while its assets have a great chance of declining.

The one adjustment that the Fed can make is a reduction in its capital. With a capital-ratio of 2.4 percent, a minor loss on its assets would make the Fed balance sheet insolvent. Note that this happens regardless of the way that you record the loss, and hence the changes to the Fed's accounting rules only superficially affect its solvency.

The Treasury is the only institution that can save the Fed when it needs to be recapitalized. We would be remiss to think that a Congress paying into the Fed instead of skimming earnings off it would remain a hands-off spectator in American monetary affairs. There is a clear incentive for Congress to start asking for favors from the Fed, which generally means — if other countries where such demands are placed on the central bank by the government are any guide — higher levels of money printing and inflation.

Luckily we are no longer the only ones discussing this problem. A new working paper by the IMF analyzes this same problem and concludes that

  1. yes, quasi-fiscal policies can be highly inflationary as central banks cannot unwind their positions, but
  2. the fiscal authority (i.e., the Treasury) can come to their aid to help them do so.

What the authors fail to address is what happens when the central bank becomes explicitly accountable to the Treasury and dependent on its funding to operate. If the Fed continues its policies of purchasing low-quality assets from the banking system to stabilize it, we might just find out. I for one would rather leave that question to the theory outlined above — and not put it into practice.

David Howden is a PhD candidate at the Universidad Rey Juan Carlos, in Madrid, and winner of the Mises Institute's Douglas E. French Prize. Send him mail. See his article archives. Comment on the blog.

© 2012 Copyright Ludwig von Mises - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

© 2005-2019 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.

Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules