Best of the Week
Most Popular
1. Investing in a Bubble Mania Stock Market Trending Towards Financial Crisis 2.0 CRASH! - 9th Sep 21
2.Tech Stocks Bubble Valuations 2000 vs 2021 - 25th Sep 21
3.Stock Market FOMO Going into Crash Season - 8th Oct 21
4.Stock Market FOMO Hits September Brick Wall - Evergrande China's Lehman's Moment - 22nd Sep 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.How to Protect Your Self From a Stock Market CRASH / Bear Market? - 14th Oct 21
7.AI Stocks Portfolio Buying and Selling Levels Going Into Market Correction - 11th Oct 21
8.Why Silver Price Could Crash by 20%! - 5th Oct 21
9.Powell: Inflation Might Not Be Transitory, After All - 3rd Oct 21
10.Global Stock Markets Topped 60 Days Before the US Stocks Peaked - 23rd Sep 21
Last 7 days
Silver Long-term Trend Analysis - 28th Nov 21
Silver Mining Stocks Fundamentals - 28th Nov 21
Crude Oil Didn’t Like Thanksgiving Turkey This Year - 28th Nov 21
Sheffield First Snow Winter 2021 - Snowballs and Snowmen Fun - 28th Nov 21
Stock Market Investing LESSON - Buying Value - 27th Nov 21
Corsair MP600 NVME M.2 SSD 66% Performance Loss After 6 Months of Use - Benchmark Tests - 27th Nov 21
Stock Maket Trading Lesson - How to REALLY Trade Markets - 26th Nov 21
SILVER Price Trend Analysis - 26th Nov 21
Federal Reserve Asks Americans to Eat Soy “Meat” for Thanksgiving - 26th Nov 21
Is the S&P 500 Topping or Just Consolidating? - 26th Nov 21
Is a Bigger Drop in Gold Price Just Around the Corner? - 26th Nov 21
Financial Stocks ETF Sector XLF Pullback Sets Up A New $43.60 Upside Target - 26th Nov 21
A Couple of Things to Think About Before Buying Shares - 25th Nov 21
UK Best Fixed Rate Tariff Deal is to NOT FIX Gas and Electric Energy Tariffs During Winter 2021-22 - 25th Nov 21
Stock Market Begins it's Year End Seasonal Santa Rally - 24th Nov 21
How Silver Can Conquer $50+ in 2022 - 24th Nov 21
Stock Market Betting on Hawkish Fed - 24th Nov 21
Stock Market Elliott Wave Trend Forecast - 24th Nov 21
Your once-a-year All-Access Financial Markets Analysis Pass - 24th Nov 21
Did Zillow’s $300 million flop prove me wrong? - 24th Nov 21
Now Malaysian Drivers Renew Their Kurnia Car Insurance Online With Fincrew.my - 24th Nov 21
Gold / Silver Ratio - 23rd Nov 21
Stock Market Sentiment Speaks: Can We Get To 5500SPX In 2022? But 4440SPX Comes First - 23rd Nov 21
A Month-to-month breakdown of how Much Money Individuals are Spending on Stocks - 23rd Nov 21
S&P 500: Rallying Tech Stocks vs. Plummeting Oil Stocks - 23rd Nov 21
Like the Latest Bond Flick, the US Dollar Has No Time to Die - 23rd Nov 21
Why BITCOIN NEW ALL TIME HIGH Changes EVERYTHING! - 22nd Nov 21
Cannabis ETF MJ Basing & Volatility Patterns - 22nd Nov 21
The Most Important Lesson Learned from this COVID Pandemic - 22nd Nov 21
Dow Stock Market Trend Analysis - 22nd Nov 21
UK Covid-19 Booster Jabs Moderna, Pfizer Are They Worth the Risk of Side effects, Illness? - 22nd Nov 21
US Dollar vs Yields vs Stock Market Trends - 20th Nov 21
Inflation Risk: Milton Friedman Would Buy Gold Right Now - 20th Nov 21
How to Determine if It’s Time for You to Outsource Your Packaging Requirements to a Contract Packer - 20th Nov 21
2 easy ways to play Facebook’s Metaverse Spending Spree - 20th Nov 21
Stock Market Margin Debt WARNING! - 19th Nov 21
Gold Mid-Tier Stocks Q3’21 Fundamentals - 19th Nov 21
Protect Your Wealth From PERMANENT Transitory Inflation - 19th Nov 21
Investors Expect High Inflation. Golden Inquisition Ahead? - 19th Nov 21
Will the Senate Confirm a Marxist to Oversee the U.S. Currency System? - 19th Nov 21
When Even Stock Market Bears Act Bullishly (What It May Mean) - 19th Nov 21
Chinese People do NOT Eat Dogs Newspeak - 18th Nov 21
CHINOBLE! Evergrande Reality Exposes China Fiction! - 18th Nov 21
Kondratieff Full-Season Stock Market Sector Rotation - 18th Nov 21
What Stock Market Trends Will Drive Through To 2022? - 18th Nov 21
How to Jump Start Your Motherboard Without a Power Button With Just a Screwdriver - 18th Nov 21
Bitcoin & Ethereum 2021 Trend - 18th Nov 21
FREE TRADE How to Get 2 FREE SHARES Fractional Investing Platform and ISA Specs - 18th Nov 21
Inflation Ain’t Transitory – But the Fed’s Credibility Is - 18th Nov 21
The real reason Facebook just went “all in” on the metaverse - 18th Nov 21
Biden Signs a Bill to Revive Infrastructure… and Gold! - 18th Nov 21
Silver vs US Dollar - 17th Nov 21
Silver Supply and Demand Balance - 17th Nov 21
Sentiment Speaks: This Stock Market Makes Absolutely No Sense - 17th Nov 21
Biden Spending to Build Back Stagflation - 17th Nov 21
Meshing Cryptocurrency Wealth Generation With Global Fiat Money Demise - 17th Nov 21
Dow Stock Market Trend Forecast Into Mid 2022 - 16th Nov 21
Stock Market Minor Cycle Correcting - 16th Nov 21
The INFLATION MEGA-TREND - Ripples of Deflation on an Ocean of Inflation! - 16th Nov 21

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

Can the Fed Successfully Exit Liquidity Flood Policies ?

Interest-Rates / Credit Crisis 2010 Aug 03, 2010 - 09:18 AM GMT

By: David_Howden

Interest-Rates

Best Financial Markets Analysis ArticleThe Federal Reserve Bank of Minneapolis recently interviewed macroeconomist Robert Hall for the June issue of its quarterly magazine, The Region. His words on the Federal Reserve's ability to enact an exit strategy to unwind its unconventional policies were clear and sure: "There are two branches to the exit strategy: There's paying interest on reserves, and there's reducing reserves back to normal levels. They're both completely safe, so it's a nonissue."


Before addressing the question of whether the exit strategy is really "completely safe" or a "nonissue", we must first address the specifics of these two components.

In the wake of the credit crisis of late 2008, the Federal Reserve flooded the banking sector with liquidity. The Fed purchased troubled assets in exchange for base money. Since the banking system was not prepared to immediately loan this new base money, the system's reserves increased dramatically. The Fed concomitantly commenced paying interest on these reserves to remove the incentive for them to be fully used. In theory, by removing the incentive to loan out reserves, price inflation would be minimized: banks would not be constrained by their troubled loans and bad assets, and the Fed would retain credibility as an "inflation fighter."

The result was immediate and effective. As bad assets were removed from their balance sheets, banks were not forced into fire-sale situations by selling their assets to maintain regulatory capital levels. At the same time the Fed was able to save the banking sector via an increase in available credit without causing inflationary pressures to build.

While the short-term effects were seemingly beneficial and controlled, the long-term outlook is much less certain.

The Fed's liquidity injection was made by issuing credit to banks and simultaneously buying back troubled (i.e., subprime) banking sector assets. While the banking sector's balance sheet ballooned with cash and cash equivalents, the Fed's own balance sheet witnessed a sharp rise in the very troubled assets it was removing from the banking system. As Philipp Bagus recently noted, the Fed had become exactly the type of "bad bank" it had tried to rescue.

The figure below outlines the growth in the Fed's balance-sheet policies during the crisis.

Figure 1: Banking system loans initiated by the Federal Reserve System

Source: Federal Reserve Statistical Release H.4.1 ($bn., monthly: Jan. 2008 — Jul. 2010)

Some of the enacted programs were self-liquidating, and now pose minimal danger to the financial system (central-bank liquidity swaps spring to mind, as does the money-market mutual-fund liquidity provision). Other programs have continued growing and cannot be so easily phased out. Over $1.1 trillion of mortgage-backed securities have been purchased since March 1, 2009. These assets, typically rated subprime, are of questionable quality (with total assets of almost $2.4 trillion as of July 1, 2010, nearly half of the Fed's total assets are subprime). More troubling is that these mortgages cannot be properly valued until they are sold to a willing buyer — buyers who are increasingly in short supply.

This "qualitative easing" — the purchasing of low-quality assets from the banking sector in exchange for high-quality assets from the central bank — persisted until central banks lacked adequate high-quality assets to continue the policy. It was only at this point that the more obvious policy of "quantitative easing" was pursued.

Philipp Bagus and I have been among a minority of economists who have signaled the occurrence of this policy (both by the Fed and the European Central Bank), and, more importantly, its detrimental ramifications. The long-term implications of this policy are now becoming evident.

As the Fed withdrew these troubled assets from the banking system, they were offset by issuing increasing amounts of Federal Reserve liabilities — cash. By offering an interest payment on reserve holdings, banks were incentivized to hold on to this newfound liquidity, thus nullifying any inflationary effects the policy could immediately cause. And as Robert Hall correctly notes, one exit strategy the Fed now has is the continual payment of interest on these reserves. As long as banks can profitably hold the 1.1 trillion extra dollars of monetary base that the Fed has created since August 2008, no inflationary pressures will build.

The reality may be very different from what Hall's theory suggests. As the figure below shows, the banking system now receives around $230 million each and every month for doing nothing other than holding on to the assets they passively received in exchange for their low-quality mortgage-backed securities.

Figure 2: Monthly Federal Reserve System interest paid on reserves

Source: Federal Reserve Board of Governors release H.3 (Aug. 2008 — Jul. 2010)

Three billion dollars a year in interest payments is a large portion of the Fed's annual operating profits. The recipients — America's large and not-so-large banking establishments — are now much less hindered by subprime loans than they were two years ago. How much longer the Fed can give the banking sector billions of dollars to hold on to these reserves is questionable. Politically, it seems unlikely that Americans will continue to support these payments. Economically, the Fed is losing a large portion of its operating profits to these payments.

Despite these troubling aspects, the banking system's subprime situation is being alleviated. The Fed continues its policy of buying these mortgage-backed securities from the banking sector in order to maintain stability. This is a show of force, an attempt to demonstrate that the Fed is in full control of the situation.

Full control, however, is exactly what the Fed does not have. The alternative exit strategy, if financial stability is to be maintained without runaway inflation, is for the Fed to simply swap the "bad" assets on its own balance sheet for the "good" assets of the banking system.

Herein lies the rub. Inflationary pressures could be neutralized if the aggregate value of the assets originally purchased by the Fed is equivalent to the aggregate value of the assets now being returned. We should take comfort in knowing that at least one of these numbers is known with some degree of exactness. The cash now resting as reserves, and more importantly excess reserves, on the banking system's balance sheet can be valued at par: more or less, there are $1.1 trillion waiting on the sidelines for the Fed to reabsorb.

The value of the mortgage-backed securities that the Fed holds is far less certain. While the reported value on its balance sheet is $1.1 trillion, we should note that the Fed is balancing its books based on the current face values of these securities. These trillion odd dollars represent the outstanding principle on this debt, which is guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. While these assets may have been purchased originally by the Fed for this recorded amount, the maintenance of this value is questionable.

At what discount are securities backed by and comprised of Las Vegas gambling parlors and Miami vacation rentals selling today? We don't know for certain, and more troubling, we won't know what discount a trillion dollars worth of these securities will sell at until the market finds buyers for them. Presumably, the Fed purchased the lowest-quality assets that the banking system held: removing the most "toxic" assets to aid bank capitalization levels. Knowing that the Fed now holds the most toxic of the subprime assets the banking system could create during the roaring 2000s should leave us with some concern.

What then of the Fed's exit strategy? Ben Bernanke and Robert Hall, along with a multitude of fellow central bankers and economists, have stressed that there is no technical problem in exiting these positions. This is theoretically true — until reality sets in.

Any Fed-enacted swap of its subprime assets for the excess reserves of the banking system will result in some degree of inflation if the two values do not coincide. An upper and lower bound for future price inflation can be approximated from this differential.

At the upper bound, as several commentators such as Robert Murphy have warned, is the outcome where the Fed does nothing to reign in excess reserves. In this case, the Fed will have created $1.1 trillion worth of inflation.

More importantly, we can estimate the lower bound for the Fed-created inflation. The value differential between the excess reserves in the banking system and the subprime assets held by the Fed will remain in the banking sector indefinitely. As the Fed can only purchase back from the banking system reserves of equal value to its available assets, any drop in the value of its own assets will result in excess reserves remaining in the hands of the banking sector — waiting to manifest as price inflation when finally utilized.

Neither bound, upper nor lower, seems particularly attractive.

The silver lining in all this may be that any inflationary pressures will have to wait for another day. The Fed will not enact either exit strategy until the banking sector is back on firm footing, lest a tenuous situation worsen. With several banks entering insolvency weekly, the Fed is in no position to start unwinding any of its balance-sheet policies designed to aid the struggling sector.

Until the day comes when the Fed deems the banking sector able to stand on its own two feet — either with its subprime mortgages back, or without the interest payment on its reserve holdings — inflationary pressure on prices will remain low. But until the Fed finally decides to unwind its subprime balance-sheet positions, entrepreneurs will have to function in an era of uncertainty as to what price inflation lies ahead.

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.

© 2010 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 http://www.MarketOracle.co.uk - 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