Federal Reserve Paper Warns of Possible Monetary Crisis

[Ad Orientem]

A new paper for the US Monetary Policy Forum and published by the Fed warns that the institution's capital base could be wiped out "several times" once borrowing costs start to rise in earnest.

A mere whiff of inflation or more likely stagflation would cause a bond market rout, leaving the Fed nursing escalating losses on its $2.9 trillion holdings. This portfolio is rising by $85bn each month under QE3. The longer it goes on, the greater the risk. Exit will become much harder by 2014.

Such losses would lead to a political storm on Capitol Hill and risk a crisis of confidence. The paper -- "Crunch Time: Fiscal Crises and the Role of Monetary Policy" -- is co-written by former Fed governor Frederic Mishkin, Ben Bernanke's former right-hand man.

Read the rest here...
http://www.telegraph.co.uk/finance/comm ... st-QE.html

[melveyr]

My favorite part about finance/economics: given enough time everyone can be held accountable.

I would bet heavily against this paper with respect to US, UK, and Japanese debt markets. Let's check back in ten years 

[moda0306]

A mere whiff of inflation or more likely stagflation would cause a bond market rout.

It seems now that they realize it's ridiculous to try to worry about the "liabilities" issued in our government's own currency, we now have to worry about the "assets" on the fed's balance sheet when they go down in value.

For a better takedown, here's Cullen's take from MR.

http://pragcap.com/will-the-fed-end-up- ... e-programs

[Ad Orientem]

I don't care for the way the Telegraph portrayed the report. It's fairly long (90 pages in pdf) and quite nuanced. But yes it does paint a grim picture.

[MachineGhost]

What is new is that these worries are surfacing openly in Fed circles. The Mishkin paper almost certainly reflects a strand of thinking at Constitution Avenue, so there may be more than meets the eye in last week's Fed minutes, which rattled bourses across the world with hints of early exit from QE.

Wowowowowowow, I'm sure glad someone is not asleep at the wheel!

[moda0306]

Ok let's try walking through this.

First comes inflation (or recovery, maybe?) which will require a rise in rates.  Because of the duration of the fed's bonds, this will decimate their balance sheet...

So what's the end game of this?  The fed has paid billions back to the treasury in the form of interest.  Is there some limitation to the "funding" of the Fed's balance sheet should it go awry?

I really don't see the fed's balance sheet as anything more than an accounting tracking scheme with names held over from the gold standard days.

[dualstow]

The same author had a pretty intense warning  in the summer of 2008. But, I'm not sure if that is before or after the crash had already begun. 

[MachineGhost]

So what's the end game of this?  The fed has paid billions back to the treasury in the form of interest.  Is there some limitation to the "funding" of the Fed's balance sheet should it go awry?

With a central bank that is beyond bankruptcy several times over, it seems to me it would really devalue the dollar since it is the Fed's balance sheet that is backing it.

The Fed doesn't have to raise rates if the economy doesn't recover.  It also doesn't have to sell off its balance sheet just to avoid inflation, it can transmit the devaluation indirectly to the general price level.  Post-Keynesians, like Cullen, don't believe in general equilibrium theory where prices of competing investments in an economy adjust relative to each other.

[moda0306]

MG,

How do you see the fed as bankrupt?  What do you think truly "backs" the value of the US dollar?

[MachineGhost]

How do you see the fed as bankrupt?  What do you think truly "backs" the value of the US dollar?

The standard definition of any bankruptcy: liabilities > assets.

If you want to add intangible goodwill to the Fed's balance sheet, you'll have no argument with me.  But would it be enough to go back into the black?  The Fed is leveraged over 50:1.  If you think holding LT Treasuries is risky right now, imagine holding LT Federal Reserve Bonds...  thank gawd our Federal Reserve Notes have a duration of 0.

If we didn't have these "anarchronistic" accounting controls and taxes (and fiscal conservatives), we'd be a high inflationary basketcase like Argentina, that is probably on its way to hyperinflation.

[Ad Orientem]

I really encourage reading the actual report ...
http://research.chicagobooth.edu/igm/us ... load2.aspx

[moda0306]

Ad,

I'll try, but when a 90-page document starts with this statement...

Countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders lead to higher sovereign interest rates which in turn make the debt problems more severe.

...it's going to be hard for me to take the rest too seriouly.  Hopefully they at least flesh out the role of a sovereign currency issuer.

I find it immensely interesting that the liabilities that deficit-hawks are so afraid of are the exact same contract that these authors seem to be so afraid are going to drop too much in value on the fed's balance sheet.

[MachineGhost]

I find it immensely interesting that the liabilities that deficit-hawks are so afraid of are the exact same contract that these authors seem to be so afraid are going to drop too much in value on the fed's balance sheet.

They also believe the Fed is independent and prints money.  It a triumvirate!

But don't overestimate facts vs perceptions.  Perceptions are all that matters, especially in a panic/crisis.  As Humpty-Dumpty said, "The question is which is to be master -- that is all"!

[craigr]

Ad,

I'll try, but when a 90-page document starts with this statement...

Countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders lead to higher sovereign interest rates which in turn make the debt problems more severe.

...it's going to be hard for me to take the rest too seriouly.  Hopefully they at least flesh out the role of a sovereign currency issuer.

So what's wrong with that statement? It's factually correct. If investors don't trust a debt issuer, they can't issue debt. Even if they print their own money, it only gets you so far. There are not only foreigners who refuse to buy the debt, but also the citizens. Good assets will flee and/or go underground and not be used to fund bad debt nor accept the currency of someone that is viewed as a bad credit risk.

[moda0306]

MG,

Please explain to me how the fed's balance sheet should be viewed in a vacuum, and not as intermingled with both the treasury and even in some ways with the broader economy?

Please explain how the fed is "leveraged 50-to-1."


And Ad,

I can't read this thing.  The math alone is far above my head.  Do you understand all the algebra? If not, no offense, but how can you possibly suggest that reading this thing will answer any questions or lend any light on any of this?

[moda0306]

Ad,

I'll try, but when a 90-page document starts with this statement...

Countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders lead to higher sovereign interest rates which in turn make the debt problems more severe.

...it's going to be hard for me to take the rest too seriouly.  Hopefully they at least flesh out the role of a sovereign currency issuer.

So what's wrong with that statement? It's factually correct. If investors don't trust a debt issuer, they can't issue debt. Even if they print their own money, it only gets you so far. There are not only foreigners who refuse to buy the debt, but also the citizens. Good assets will flee and/or go underground and not be used to fund bad debt nor accept the currency of someone that is viewed as a bad credit risk.

When we have countries like Japan w/ 200% debt/gdp and the lowest sovereign debt rates in the world, I think this has to be analyzed much more than the initial paragraph's simple analysis delves into.  Currencies collapse much more as a result of non-monetary circumstances (wars, mass confiscation, foreign-denominated debt (often as a result of losing a war).  It's not just "they printed too much money." 

[MachineGhost]

Please explain to me how the fed's balance sheet should be viewed in a vacuum, and not as intermingled with both the treasury and even in some ways with the broader economy?

Please explain how the fed is "leveraged 50-to-1."

I'm actually saying the Fed is not a vacuum, but MR Post-Keynesians like Cullen treat it as such with their flippant inside-the-box dismissals.

The Fed's balance sheet is $3 trillion.  Total capital is $55 billion.  3000 / 55 = 55x.  Duration is 8 years.  A 1% move in rates wipes out $250 billion.  There is no marking to market, but do you believe currency holders are that stupid?  It seemed to work for the banks, though.

The other problem is the Fed could crowd out private savings if it gobbles up all the Treasuries to repair its balance sheet.

[moda0306]

The whole idea that a country that is sovereign in its own currency issuance (to the degree it hasn't outsourced the job to banks) has to issue bonds or collect taxes in their traditional roles is a bit asinine, so looking at the quantity of M0 currency in circulation going up and looking at it as the government paying off its debts with printed money is equally ridiculous.  So what are bonds and taxes in a sovereign fiat world? 

Answer: Simply tools for government to use to control the price of money.

There's no true mechanism to get people to value green pieces of paper like the government requiring taxes be paid in those dollars.  It worked in Africa when the British introduced their currency there.  It's simply an inflation control device.

Likewise, bonds are simply a tool to slow down "inside money" created by the banks.  Treasury bond rates act as a price floor for bank lending.  AKA, nobody would borrow money to a municipality or corporation or individual at a lower rate than the base treasury rate.  By these means, the government controls lending to a certain degree (most of it is controlled by banks).

So our bonds are effectively savings accounts with the US government, and are probably as close to being actual money as you can get.  Why should the government swapping a fiat asset for a fiat asset have any effect on the confidence in the dollar, unless it facilitates the price floor to be so low compared to the rate of inflation that lending becomes rampant and holding dollars as a reasonable store of value (interest rate adjusted) becomes a horrible idea. 

Right now, people NEED the dollars they have in the bank, even if they're losing 2% per year in real value to inflation.  There is no mechanism for them to lose faith in the asset that they desperately need to pay their bills and debts, and have spent years not getting very big increases in payments of by their bosses.  Take the average US family's balance sheet and explain to me how, even after all the QE the fed has done, they have ANY capacity to "reject" the dollar.

[moda0306]

Please explain to me how the fed's balance sheet should be viewed in a vacuum, and not as intermingled with both the treasury and even in some ways with the broader economy?

Please explain how the fed is "leveraged 50-to-1."

I'm actually saying the Fed is not a vacuum, but MR Post-Keynesians like Cullen treat it as such with their flippant inside-the-box dismissals.

The Fed's balance sheet is $3 trillion.  Total capital is $55 billion.  3000 / 55 = 55x.  Duration is 8 years.  A 1% move in rates wipes out $250 billion.  There is no marking to market, but do you believe currency holders are that stupid?  It seemed to work for the banks, though.

The other problem is the Fed could crowd out private savings if it gobbles up all the Treasuries to repair its balance sheet.

CR views the fed for what it is, IMO, an entity tightly intermingled with "private" banks and the treasury/congress.  The $3 Trillion in base money is simply listed as a "liability" on the fed's balance sheet.  Last I checked, the fed owned about 10% of our debt, which puts it at 1.5 Trillion.  That doesn't even count MBS's.  I don't know what you claim is "capital," though.  Where did the $55 billion come from?

Either way, it's just accounting gimmicks until you look at how this all interacts with the broader economy.  Do you really think that the value of our currency is built on a balance sheet of only one piece of the money-creation pie denominated in that very currency?  I mean they pay their profits to the treasury... is it so hard to imagine tha if they run a "loss" that they'll be replenished by the same entity?

Is the fed really "crowding out private savings?"  Both dollas themselves and bonds are both "savings."  One just happens to pay interest.  I think we would agree that QE results in a fall in interest rates, and that this might make saving less enticing, but this has to be viewed in the context of the fact that in our current fiat world, interest on treasuries is simply a price floor to help control lending, not a government funding mechanism.

[MachineGhost]

So our bonds are effectively savings accounts with the US government, and are probably as close to being actual money as you can get.  Why should the government swapping a fiat asset for a fiat asset have any effect on the confidence in the dollar, unless it facilitates the price floor to be so low compared to the rate of inflation that lending becomes rampant and holding dollars as a reasonable store of value (interest rate adjusted) becomes a horrible idea.

Keep in mind the vast majority of that $3 trillion on the Fed's balance sheet is illegally-acquired mortgage backed securities, not Treasury securities.  That is not fiat for fiat.  The credit quality is not even remotely the same, even if it is ultimately back-stopped by the Treasury.  The uncertainly alone is enough.

The problem I have with your view is it is along the same lines of how politics work.  They will do anything as long as it is politically expedient, even unconstitutional, extralegal or illegal activities.  There has to be a rule of law or we'll wind up like... yep, Argentina.

I feel like I'm barking up a tree though.  The trend is obvious.  And it is not up.

[MachineGhost]

Where did the $55 billion come from?

http://www.federalreserve.gov/monetaryp ... nces_p.htm

Either way, it's just accounting gimmicks until you look at how this all interacts with the broader economy.  Do you really think that the value of our currency is built on a balance sheet of only one piece of the money-creation pie denominated in that very currency?  I mean they pay their profits to the treasury... is it so hard to imagine tha if they run a "loss" that they'll be replenished by the same entity?

Not at all.  But again my point is that under the general equilibrium theory, the devaluation of the Fed's balance sheet will devalue the dollar.  People will see to it.  That will be a real world loss of purchasing power compared to the Fed's "virtual" loss.

Is the fed really "crowding out private savings?"  Both dollas themselves and bonds are both "savings."  One just happens to pay interest.  I think we would agree that QE results in a fall in interest rates, and that this might make saving less enticing, but this has to be viewed in the context of the fact that in our current fiat world, interest on treasuries is simply a price floor to help control lending, not a government funding mechanism.

In the primary auction, what the Fed eats, the investors do not get to claim for their own savings.

[moda0306]

Is the fed really "crowding out private savings?"  Both dollas themselves and bonds are both "savings."  One just happens to pay interest.  I think we would agree that QE results in a fall in interest rates, and that this might make saving less enticing, but this has to be viewed in the context of the fact that in our current fiat world, interest on treasuries is simply a price floor to help control lending, not a government funding mechanism.

In the primary auction, what the Fed eats, the investors do not get to claim for their own savings.

Yes they do.  They get $'s back of equal value.  Dollars I hold in my hand are just as much "savings" as a treasury bond.

[MachineGhost]

Yes they do.  They get $'s back of equal value.  Dollars I hold in my hand are just as much "savings" as a treasury bond.

They have no way to park their money in the savings vehicle if the Fed first gobbles it all up, yes?  Cash [currency] isn't savings (it is 0 maturity).  This is why it is said the Fed can only change the amount of debt the public does or does not hold as opposed to "printing money".  Besides, I think coins and currency is under the aegis of the Treasury anyway not the Fed.

[moda0306]

So our bonds are effectively savings accounts with the US government, and are probably as close to being actual money as you can get.  Why should the government swapping a fiat asset for a fiat asset have any effect on the confidence in the dollar, unless it facilitates the price floor to be so low compared to the rate of inflation that lending becomes rampant and holding dollars as a reasonable store of value (interest rate adjusted) becomes a horrible idea.

Keep in mind the vast majority of that $3 trillion on the Fed's balance sheet is illegally-acquired mortgage backed securities, not Treasury securities.  That is not fiat for fiat.  The credit quality is not even remotely the same, even if it is ultimately back-stopped by the Treasury.  The uncertainly alone is enough.

The problem I have with your view is it is along the same lines of how politics work.  They will do anything as long as it is politically expedient, even unconstitutional, extralegal or illegal activities.  There has to be a rule of law or we'll wind up like... yep, Argentina.

I feel like I'm barking up a tree though.  The trend is obvious.  And it is not up.

MG, what are you seeing as the assets and liabilities of the fed.  The $3 trillion is M0.  That's their "liability."  The MBS is an asset.  I still don't see where you're gettng the $55 billion of capital.

I still don't see how a central bank's balance sheet can be viewed as the foundation of the value of a currency.  There's no bite there.  The value of our currency comes from a combination of taxes, "proper" lending in the banking sector (for all the complaints, a ton of lending is very legitimate and necessary, and often focused in positive areas), and government supporting an expansion of productive capacity and confidence.  To me, some nebulous fed balance sheet has little to do with it.

[moda0306]

Yes they do.  They get $'s back of equal value.  Dollars I hold in my hand are just as much "savings" as a treasury bond.

They have no way to park their money in the savings vehicle if the Fed first gobbles it all up, yes?  Cash [currency] isn't savings (it is 0 maturity).  This is why it is said the Fed can only change the amount of debt the public does or does not hold as opposed to "printing money".  Besides, I think coins and currency is under the aegis of the Treasury anyway not the Fed.

The money IS savings.  "Saving" is the act of not spending income.  "Savings" is the money one has saved.  Maybe we're working with different definitions here.  The fed can't change private sector savings... it can simply change its form from one to another.