The Problem with a Staged Federal Reserve Retreat

Get out your tea leaves — it’s that time again.

‘On Wednesday,’ writes John Beveridge, ‘Bernanke and his board will discuss their next step as they try to engineer a staged retreat from some of the most extraordinary money printing stimulus the U.S. has ever seen.’

Once again, Wall Street will hang on each word with nauseating myopia trying to determine if infinite quantitative easing will soon become finite.

That’s the problem with a staged retreat: Everyone’s watching for it and reacts accordingly.

‘Last month,’ Beveridge continues, ‘when Bernanke told Congress he was thinking about starting to wheel the punch bowl toward the kitchen if things kept going well, the party began to get out of hand. Markets and currencies gyrated as they considered what would happen if the U.S. Fed scaled back its program of buying $85 billion of government bonds every month.’

Macro strategist Dan Amoss lays out the play-by-play:

A key plank of the Fed’s exit strategy involves paying higher interest rates on excess reserves. This would have the effect of keeping the huge stock of recently printed money on deposit at the Fed, preventing it from entering circulation out in the real economy.

While that may sound fine in theory, here’s the political problem: The Fed would wind up paying hundreds of billions of dollars in interest payments on its liabilities — after it has already locked in low rates on its assets by buying low-yielding Treasuries and mortgage securities. Like a bank in a flat yield curve environment, the Fed’s net interest income would vanish — along with its annual remittances to the Treasury. These remittances have cut the U.S. Treasury’s financing burden by hundreds of billions of dollars since 2008…

If the Fed loses the ability to pay interest on excess reserves (which Congress granted in the 2008 crisis), it will have to use much more painful ‘open market operations.’ Tightening policy using open market operations would involve selling Treasuries and mortgages into a collapsing, bidless bond market while erasing previously printed base money supplies. You can imagine what a disaster this would be for the prices of all ‘risk’ assets. The rush to sell everything (stocks, bonds, real estate) would be unprecedented.

That’s why we figure that Wall Street’s palm readers will be left guessing after the Federal Reserve announces.

Mortgage rates have already spiked just above 4% last week and our credit addiction hasn’t really changed.

Below you can see what consumer debt looks like.

It’s dropped by about $1.2 trillion from a high of $14 trillion in 2008, but that doesn’t mean we’re out of the woods:

Moreover, total debt across all sectors has risen to almost $60 trillion…almost 4 times the nation’s income.

Ironically, former Federal Reserve chairman Alan Greenspan explained why such a debt kick is like dancing on the ledge:

‘The comparable measure with respect to households is that if you don’t save adequately, you are wholly dependent upon the income you are getting. But as far as you’re concerned, unless you put money away for nest egg purposes, for retirement, for a variety of other purposes, you will find that you are living an extraordinarily precarious existence. Savings is the buffer which is the gap between disaster and prosperity.’

‘Gosh,’ one reader commented after reading those words. ‘He espouses Austrian principles before and after he’s the head of the Federal Reserve. And our leaders try to have us believe that the institution isn’t politicized?’


Peter Coyne
for Markets and Money

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4 Comments on "The Problem with a Staged Federal Reserve Retreat"

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Bankrupt you Bernanke doesn’t know the difference between money & liquid assets. The money stock stagnated for 4 straight years (esp. relative to real-gDp). The Case-Shiller home price index began fallling after 2 years of tightening. Bernanke continued to strangle the economy – forcing down asset prices & increasing counterparty risk. This created a liquidity crisis.

No one will be able to re-write this historical record. The guy’s academic record is not matched by his perfromance in the free market

And the IOeR policy shows how ignorant Bernanke is. You can’t take reserves nor money out of the commercial banking system (unless you hoard currency) – depending upon monetary policy. By allowing the Central Bank to pay interest on excess reserve balances it induces non-bank dis-intermediation (an outflow of funds or negative cash flow). Dis-intermediation for the CBs hasn’t been predicated on interest rate ceilings since 1933. This is where the size of the non-banks shrink, but the size of the commercial banking system remains uneffected. This is the same paradigm as the 1966 S&L crisis where Reg. Q ceilings… Read more »
It is like a fire cracker rocket. It zooms up, everyone is delirious with happiness. The rocker slows…appears to stop in mid air then hangs there to the sound of amazed gasps before suddenly falling straight down. Shit is trumps and all the kids run for cover. I watched the ABC Business show last night and the Bank nuts where discussing US job and economic figures as if they are real. As if any of it is real. Chinas economy will be next in the wok … three laps and it is over bar WW3. It is to much for… Read more »

They all go to the same school of cognitive dissonance.

Meanwhile, caucus kicks Boehner ….

Something to cheer for, for a change!

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