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Friday, February 22, 2013

More Shots Fired In FEDWar

The debate is heating up quite quickly:
The economists say that the Fed could incur substantial losses that might occur when U.S. deficits are still high and Congress and the White House have been unable to put fiscal policy on a sustainable trajectory. 

“This unfavorable fiscal arithmetic might tend to push the Fed toward delaying its exit from the extraordinary easing measures it has taken in recent years; it could even affect decisions this year about how much further to expand the Fed’s holdings of longer-term government securities,” the authors said. “The Fed could cut its effective drain on the Treasury significantly by putting off asset sales and delaying policy rate increases. But such a response would presumably feed rising inflation expectations.”  
The paper is not officially "out" yet, but I am sure it will be circulated. This line of argument addresses the FOMC comment that the Fed's future losses wouldn't affect monetary policy. Of course they could. They could because they restrict its actions, and while it wouldn't necessarily be other than a confidence problem (which is a huge issue for a central bank) in another set of circumstanes, the current US context is that we run huge fiscal deficits as far as the eye can see into the future.

The real issue here is the federal budget interacting with the Fed's larded up balance sheet. If the Fed cannot unwind that as needed, of course the Fed's ability to control inflation is limited. For the Fed to unwind it quickly, the Fed would need a subsidy from the federal government.

Eventually, lending will pick up. Experience suggests that will occur between 2016 and 2018. Normally it would pick up substantially by 2015, but the pickup has been artificially delayed by the attempt to recover the housing disaster. When lending picks up, the massive insertion of money into the system that has occurred as a result of our badabing-baddaboom excursion into Bubblenomics will fuel massive inflation. 

If the Fed cannot intervene soon enough - and nothing at this time suggests that it can, and everything suggests that its ability to do so gets weaker by the month - the only recourse would be much higher taxation down to about the median level of household incomes. Only that can somewhat restrain borrowing and an uncontrolled growth of the money supply. 

Nobody should ignore this risk. Countries with welfare schemes as expansive as ours and demographic shifts as deep as ours cannot afford high inflation, because it jacks up the rate of social spending faster than private real incomes for most can possibly increase, thus creating a chain of economic consequences that are anything but virtuous.

I'm calling Bernanke "Leo Bloom" from now on: There's no way out, there's no way out, there's no way out.... Well, maybe Ben Bialystock is a better name.

In other exciting news: It takes an average of 697 days to complete a foreclosure action in Illinois, according to RealtyTrac.
So, if I'm understanding this correctly (which I'm probably not), the claim is that the Fed will be constrained in its ability to sell down its balance sheet as inflation picks up because then it won't be sending the coupon payments back to the Treasury to reduce the deficit.

More succinctly, the Fed can't allow interest rates to go up because then the interest on the debt would bust the Federal budget, am I right? If the Treasury could pay its bills without Fed support, then normal operations would support the Fed.

It seems to me that this has very little to do with the size of the Fed's balance sheet, and an awful lot to do with the size of the Federal deficit (plus present value of unfunded liabilities). If they knew that Congress+Executive would get the budget under control in the next two years, there'd be little worry about the balance sheet, correct? If fiscal policy remains a mess, then the balance sheet could be zero and we'd still up a creek.

Whether it matters or not, it is important to me to get this, so as to understand the exact mechanics of the upcoming crisis.
Federal Reserve bank losses can be booked as an asset “Deferred Losses” similar to Corporations booking an asset called “Deferred Taxes”. It is an accrual accounting gimmick but they can and will do that in order to look good and keep confidence. They will justify it by saying that they will have future interest income to offset the losses incurred on the sale of bonds. They will write off the losses, that is, recognize the losses as they get future income to offset the losses thus making an accrual profit at all times.

All that matters is cash flow for themselves to pay their bills. That there would be less interest income to go to the Treasury isn’t important. That there has been a lot of interest income recently is an anomaly during these abnormal times. No country expects their central banks to fund their treasury departments directly like that in a meaningful way.

It all comes down to inflation. If velocity or commercial bank lending improves so much that inflation goes to 3% or more, they will start selling bonds, even at a loss. As MOM said, welfare states cannot afford inflation. The inflation hawks will win.

I don’t see velocity or commercial bank lending picking up much in the foreseeable future because of the anti-growth factors which are extensive.

I agree w/JC.

Why is no one talking about the huge MTM gains the Fed has or the years of interest income it has handed over to the treasury?

The answer is because it doesn't serve their purpose.

CF forecasting model has +/- 2% growth through 2016 (Which is as far as I forecast) therefore no reduction in unemployment. Which in turn means no hiking in rates.

I should clarify. By "Fed support", I did not mean interest income. I meant the purchase of Treasuries and holding them essentially interest-free.

I doubt the income from the Fed's portfolio of MBS is all that significant, but the double whammy of higher Treasury rates that actually have to be paid out to the public sure would be.

Yes, of course Neil. That is the primary danger the paper addresses.

Sorry, guys, I am temporarily very busy.
Bernanke is gone in 2014, getting out while the getting is good.
And leaving with some guaranteed cash flow for a job 'well done', or at least well executed.
What he leaves behind is the next person's problem. And everyone else's too.
All the "Fed Talk" recently just looks like this cycles version of normalizing the curve for the next Chair. A sort of cleaning the slate action if you will.
Because the Fed's actions have had such a negative effect on the real economy, Bernanke can't really raise interest rates as Greenspan did before Bernanke assumed the Chair. So he and they will have to "talk tough", and maybe even let longer rates back up a bit further as a way to set the stage for the next Fed Chair. The Fed always stays easier longer than need be, just in case. They're certainly going to be overly easy for too long this time.
They may talk tough on inflation, but that's just misdirection. Modern seigniorage is too lucrative not to employ. The wants of the few outweigh the needs of the many.
Steady as she goes...

Anon PA

Re commercial bank lending...there was a WSJ article the other day as to how this (specifically bank lending to small/midsized business) has picked up, and that some banks are even making loans at unsustainably low rates because there is so much competition.

Wonder how typical this really is, though.
How about those Italians!
Practice yourself against imminent hyperinflation. Long-harnd multiplication of 4 digit numbers.

See my homeparge: Et tu, brute
I can see why you'd not want the spam hanging around, but now my joke falls kind of flat.

Well, hope it gave you a chuckle. :-)
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