By Filipe R. Costa.
The unprecedented actions by the Federal Reserve to try to end the Great Financial Crisis and kick start the American economy have created a whole raft of unanticipated problems. How these will be solved is anyone’s guess, assuming they can even be solved at all.
It is amazing to think how much the financial world has changed in the last five years. Before 2008 the suggestion that the Fed would buy trillions of dollars of Treasuries and Mortgage Backed Securities would have (rightly!) caused an outcry. Now this is welcomed. Proposing to take interest rates to near zero and keep them there indefinitely would have been seen as deeply troubling. Again today, this is somehow seen as a good thing.
The world is on its head, but it cannot remain so forever. Market forces exist and our “leaders” seem to have forgotten this.
Were it any other organization, the path the Fed is on would almost certainly be heading straight towards bankruptcy. It currently holds $2.12trillion in Treasuries and $1.4trillion in MBSs. This is the mother lode of exposure to a deeply distorted, dysfunctional and deficient bond market. What happens if inflation really starts to rise and interest rates are forced up?
Fireworks!
When interest rates go up bond prices go down. Unless the Fed is somehow able to invent a new manipulation to break away from this established reality, this will mean the value of its $3,5trillion will drop. And you don’t need a sizeable percentage drop in its holdings to see a great deal of real “value” wiped out.
Of course, the Fed could just hang onto its potentially toxic collection of “assets”, collect the interest paid every year and wait until the bonds mature. This would mean they never need to record a loss as such, but also assumes these bonds will continue to hold their value, based on current pricing. As is likely to happen, not recording a loss could prove to be a relative term. For your average German in the Weimar Republic owning 1,000marks in 1919 was vastly different to owning 1000marks in 1922!
And there is another factor to consider. If interest rates do start to go up, then the Fed finds itself in another extremely tricky spot. The interest it receives on its bond holdings is fixed. However, the rate that the Fed has to pay on the excess reserves commercial banks hold with it is variable. Faced with fixed income and variable costs, it wouldn’t take much of an increase in rates for the Fed to need additional funding to sustain itself.
And how is a central bank likely to manage its way out of that situation?
Well, it prints more money of course!
As long as the Fed can create money out of thin air, everything is fine. At least everything is fine until the air runs out.
For everyone one else, however, the story isn’t so simple. The more money that the Fed prints the greater inflation is likely to rise in the future. This has serious implications for the rest of society. While the Fed makes its decisions to serve the interests of a select few it is grossly ignoring the costs it transfers onto the people. By reducing individual purchasing power the Fed is forcing reduced living standards on those it is meant to protect. Increasingly people will wake up to the disconnect between Fed policy and the social consequences. Nothing is a greater motivator than poverty.