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The Fed’s Terminal Dilemma: When to Begin ‘the Great Unwind’

Merle Hazard

The most financially savvy country and western crooner in America, Merle Hazard, returns with the must-watch release of a new economics chart-topper: “The Great Unwind.” As Warren Buffett previously noted, “all over the world, everybody that manages money is waiting to catch the signal that the Fed will reverse course,” and this two-minutes of country-music magnificence should concentrate the mind as “we’ve never had the degree of disgorgement that might be called for down the line, and who knows how it’ll play out.”

And for some more color from Merle Hazard’s alter-ego – money-manager Jon Shayne:

To put some meat on the bones, take a look at this chart from the Cleveland branch of the Fed:

Assets held by the Fed have soared to $3.4 trillion today. Graph courtesy of the Cleveland Fed.

The chart reflects that early in 2007, before the crisis, the Fed held $860 billion in assets. You can see, as you follow it to the right, that the Fed’s portfolio has grown to over $3.4 trillion today. In other words, the Fed has quadrupled in size. This is why my alter ego, Merle Hazard, croons that the Fed has been “buyin’ assets, by the trillion.”

What will happen if, in order to forestall inflationary pressures, the Fed needs to reverse course and, over a short period of time, sell a meaningful part of the trillions in bonds it has bought? As Buffett intimates, it would be ugly: interest rates would spike, and this could pull the stock market down sharply. We had a hint of that kind of market decline already. In June, the Fed suggested that it would start to taper off new bond purchases within several months, which means buying less, not actually selling, and this led to a temporary dip in stock prices and a rise in interest rates.

Because the effect on markets would be so negative, it is a pretty safe bet that the bonds will stay where they are, i.e., on the Fed’s balance sheet, as long as inflation stays low.

But will inflation always stay low? Maybe not. And the necessity of choosing between the risk of inflation, on the one hand, or knocking down markets, on the other other, is the dilemma that my music video is all about. As Merle puts it in the song:

 Our Fed’s the central bank to a deeply troubled nation.

If they sell off bonds, the markets tank. If not, some day, inflation.

Now the money has been flyin’, but has the Fed been flyin’ blind?

That’s why I’m worryin’ about…The Great Unwind.

There is one other option that the Fed has. Merle sings about that in the second verse:

Some say the Fed can manage this without sellin’ off its bonds;

That they’ll pay high interest on reserves, and bankers will respond.

But payin’ bankers not to lend ain’t how the system was designed,

So I’m still worryin’ about…The Great Unwind.

In other words, instead of selling bonds off to suck dollars back into the Fed, the Fed can simply pay banks to deposit money at the Fed that would otherwise be used for lending. It started using that technique in October 2008. Currently banks have $2.1 trillion deposited there, up from about zero before the crisis, and they are making 0.25 percent annually on it. That does not sound like a high rate of interest, but my clients and I are making only about a fifth of that on our U.S. Treasury bills. So the bonus rate that the Fed pays to banks raises a fairness issue.

I worry about the politics of paying bankers not to lend and the Fed’s lack of experience with this technique. Paul Solman, the proprietor of this page, has been concerned, too. As the song says, it “ain’t how the system was designed,” at least not until 2008. Granted, we have, at least in the past, paid farmers not to grow certain crops. But bankers are not quite as popular as farmers.

Paying banks interest on their reserves is also mildly inflationary in the long run, at least in the very long run, once rates move up from the floor. This is because the interest the Fed pays on bank reserves is new money.

Zero Hedge

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