Thursday, December 31, 2009

The Fed's Inflation bomb

John Carney, writing in The Business Insider, questions the Fed's ability to shrink its expanded monetary base to avoid a major inflation. "One of the sources of the growth of the monetary base has been the $1 trillion of purchases of mortgage backed securities by the Fed. . . Much of it is on deposit with the Fed itself, where banks can earn risk-free interest instead of lending it to home buyers at risk of losing their jobs or businesses still suffering from diminished consumer demand."

When bank lending starts to accelerate, the Fed will have to withdraw those funds by finding market buyers for them.
The market’s knowledge that the Fed has become a seller rather than a buyer for mortgage backed securities will likely result in the pricing of these securities falling. In order to bring the yield of these securities up to a level acceptable to the market, they will have to be sold at a discount. This discounting means that the Fed will not be able to withdraw as much liquidity as it added, leaving some portion of that $1 trillion (plus its multiplier effect) in the economy to create inflation.

Think of it this way. If the Fed bought a mortgage backed security for $100 but can only sell it for $90, there’s a 10% inflationary discount occurring. Which is to say, the Fed’s MBS has inflation built right into it. There’s no way out.
But suppose the Fed tries to fight inflation by paying higher interest rates on bank deposits at the Fed?
Right now the Fed gets away with paying very little interest, since demand for loans is low and lending risks are still perceived as high. But as opportunities in the economy grow, the Fed will have to increase the interest rates to prevent inflationary lending.

The higher rates from the Fed, of course, will cause political outrage. Essentially, bankers will be able to make handsome returns by not lending to businesses and consumers. It will be perceived—rightfully so—as a super-perverse subsidy.

And those higher rates will make it harder to sell the mortgage backed securities. The Fed will have to sell at even greater discounts, since bankers would rather just earn interest from the Fed unless the discount on the MBS—and therefore the yield—grows high enough. And, of course, each discount makes the inflation-fighting impact of the mortgage-backed-security sale less effective.

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