The Ides of March and the Fed exit strategy

The dollar bears (and inflation mongers) are all over the blogosphere and press at the moment. It is almost a consensus that the US dollar is doomed and that gold is a great investment. Sure there are doubters – but few are as vocal as Paul Krugman who refers to inflation as the phantom menace.

Anyway I thought I would have a brief analytical foray.

Over this crisis the Federal Reserve increased the money supply by literally trillions of dollars and several hundred percent. In an ordinary world this would have caused very rapid inflation – but suffice to say that this is still not an ordinary world. Short term interest rates are stuck at zero and medium term rates are pinned very close to zero. People (and financial institutions) are willing to hold (and not spend) inordinate amounts of money. Liquidity preference is very high and it has absorbed all the extra money the Fed has printed.

Obviously some day liquidity preference will wane (though Japan tells us that day might be very far into the future). When the liquidity preference has waned all that money that was printed will be excess and might turn into inflation.  The Fed will need an exit strategy. Inflation hawks are already worried that inflation is inevitable. Gold is a favoured investment of many – including some hedge fund managers who I think have very fine minds.

Ok – I think the inflation hawks are wrong and I think gold will be a lousy investment. But I need to explain why.

The Fed printed money to buy lots of riskier assets. Often these were assets owned by banks and the banks borrowed the cash from the Fed secured by these assets. About a trillion of the assets were qualifying mortgages guaranteed by Fannie and Freddie. Whatever, there is a huge increase in money supply (liabilities of the Federal Reserve) offset by an equally huge increase in assets held by the Federal Reserve.

The Fed has an exit strategy – a natural exit strategy. When people’s liquidity preference wanes they will want to hold risk-assets rather than cash. And the Fed owns trillions of dollars of risk assets. The exit strategy is simply to sell those risk assets and take back (and destroy) the cash that they created during the ciris.

The right speed to do this is also – in some sense – naturally determined. The right speed is at the speed the general public wants to hold mortgages and other risk assets again.

Now all of this presupposes something utterly critical. It presupposes that the assets on the Federal Reserve balance sheet (loans to banks secured by risk assets, Fannie and Freddie mortgages and paper) are good. If the assets held by the Federal Reserve are worthless then the Fed cannot use those assets to buy back the excess money supply precisely because those assets were a wipe-out.

The Fed has an exit strategy – but only if the asset side of its balance sheet is solid.

And this brings us back to the middle of March when the system was collapsing around us. The Fed was the only source of liquidity – they were lending to big banks secured by almost anything the big banks had unencumbered. They even lent to big banks secured by (of all things) recreational boat loans.

If everyone was insolvent then those loans to banks will be no good. The Fed will have no capacity to withdraw the excessive money supply because the asset side of their balance sheet will be stuffed.

However if the crisis was a liquidity crisis and not a solvency crisis then, come the time to exit quantitative easing, the Fed will have a sufficient balance sheet to do its part.

The determining factor as to whether the end game here is inflation is whether March was a liquidity or solvency crisis.

This blog has been consistent. I do not believe the US banking system was insolvent in March. I never did believe it. And I thus believe the Fed has an exit strategy. Given that belief I think that gold is a lousy investment from here (though thankfully I have not been short it).

More generally I think there are serious problems with believing both of the following:

(a) the financial crisis was essentially a solvency crisis – the banks were mass insolvent in March and a bailout was inevitably going to impose very large long term costs and

(b) that inflation is not a large risk.

However Paul Krugman seems to believe both these things, and he has a Nobel Prize in economics and is clearly smarter than me. So please take all of this with a grain of salt.