Friday's Wall Street Journal had a really excellent oped co-written by former Texas Senator Phil Gramm and an economics professor from Texas A & M.
The essay is worth reading closely and with some care. Some of it is "inside baseball" stuff, but a person interested in the economy and our future problems is well rewarded by reading this, even if they don't "get it" all.
If we listen to the Fed governors, the potentially explosive increase in the money supply inherent in the current $2.3 trillion of excess bank reserves won't be allowed to occur. At the first sign of a real economic recovery, the Fed will sell Treasurys and mortgage-backed securities (MBSs) to soak up excess bank reserves, or achieve the same result through repurchase agreements and paying banks to hold excess reserves.
It sounds simple, but in a full-blown recovery the Fed will have to execute its exit strategy quickly enough to keep the inflation genie in the bottle without driving interest rates up to levels that would derail the recovery. And every month that the Fed's monetary expansion continues, its exit strategy becomes more difficult and dangerous.
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Even if the Fed could sell its MBSs (note: mortgage backed secutiries), absorb its losses and withstand the public outcry as mortgage rates soared, its work would not yet be finished. The Fed would still need to move about $600 billion of U.S. Treasurys off its books to reduce excess reserves in the banking system. The effect of these sales would be substantial, since the Fed now finances 62% of the deficit and holds 18% of all marketable Treasury securities. And as a legacy of its "Operation Twist," the Fed now owns 36% of all Treasury securities with maturities between five and 10 years and 40% with maturities longer than 10 years. Selling this long-term debt would compound market disruption.
There is another complication. The Fed does not mark its assets to market. Every increase in interest rates drives down the market value of its Treasury and MBS holdings and requires the Fed to sell more and more of the book value of its portfolio to lower the monetary base by the required amount, depleting both the Feds asset holdings and earnings. For example, 30-year fixed mortgage rates have risen by 89 basis points since September 2012. Even if MBSs carried on the Fed's books were worth $100 billion when they were purchased they would sell now for less than $80 billion. The same principles apply to Treasurys where 10-year notes bought at $100 billion in April would today sell for only $90 billion.
Here's the punch line - the last two paragraphs, which I believe are inarguable.
The weakest recovery in the post-war period was bought with a fiscal policy that doubled the national debt held by the public and a monetary policy that expanded the monetary base at a rate not approached in the modern era. The monetary expansion that started as a response to the subprime crisis has evolved into a prolonged and largely unsuccessful effort to offset the negative impact of the Obama administration's tax, spend and regulatory policies.
Never in our history has so much money been spent to produce so little good, and the full bill for this failed policy has yet to arrive. No such explosion of debt has ever escaped a day of reckoning and no such monetary surge has ever had a happy ending.
As I've posted before, the only way out - if you can call it that - is inflation. It will occur eventually, even if it's still a few years off. And unless the economy picks up and demand increases, it could be quite a few years off.
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