Okay, Go Ahead, Sweat The Fed

Photo Credit: Nate Steiner || There is always enough time to panic. 😉

Today, I happened to stumble across an old article of mine: Easy In, Hard Out (Updated).  It’s kind of long, but goes into the changes that have happened at the Fed since the crisis, and points out why tightening policy might be tough.  Nothing has changed in the 2.4 years since I wrote it, so I am going to reprint the end of the article.  Let me know what you think.

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In normal times, central banks buy only government debt, and keeps the assets relatively short, at longest attempting to mimic the existing supply of government debt.  Think of it this way, purchases/sales of longer debt injects/removes liquidity for longer periods of time.  Staying short maintains flexibility.

Yes, the Fed does not mark its securities or gold to market.  Under most scenarios, it is impossible for a central bank which can issue its own currency to go broke.  Rare exceptions — home soil wars that fail, or political repudiation of the bank, where the government might create a new monetary standard, or closes the bank because of inflation.  (Hey, the central bank has been eliminated twice before.  It could happen again.)

The only real effect is on how much seigniorage the Fed remits to the Treasury, or, if things go bad, how much the Treasury would have to lend/send to the central bank in order to avoid the bad optics of negative capital, perhaps via the Supplemental Financing Account.  This isn’t trivial; when people hear the central bank is “broke,” they will do weird things.  To avoid that, the Fed’s gold will be revalued to market at minimum; hey maybe the Fed at that time will be the vanguard of market value accounting, and revalue everything.  Can you imagine what the replacement cost of the NY Fed building is?  The temple in DC?

Or, maybe the bank would be recapitalized by its member banks, if they are capable of doing so, with the reward being the preferred dividend they receive.

Back to the main point.  What effect will this abnormal monetary policy have in the future?

Scenarios

1) Growth strengthens and inflation remains low.  In this unusual combo, it will be easy for the Fed to collapse its balance sheet, and raise rates.  This is the dream scenario; and I don’t think it is likely.  Look at the global economy; there is a lot of slack capacity.