Wednesday, November 25, 2009

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.


owl said...

the collaborator of US is Paul Krugman.

geo said...

Fed has been seduced.

"Cassandra" said...

Thanks for this John.

In exemplary straight-foarward style, you articulate the anti-tin-foil-hat brigade case which is perhaps the more probable outcome. The concession I will give to both the inflationists AND the deflationists is that the distribution under the curve of possible outcomes is flatter that it has been historically, elevating the probabilities on the tails, and the distance of these tails from the more probable mean outcomes, from historically steep curves and small tails at both ends of the distribution.

Since most people react (and/or over-react) to the bias and scale of changes - be they micro earning-related or macro-oriented - rather than absolute probabilities, it is easy to understand the elevation in doomsternomics, since the dollar rate of exchange and its flip-side the gold-price, are the most visible manifestations of the micro banking system fears projected onto the macro canvas.

The most plausible skeptics will argue that while admittedly the Fed can exit as you've suggested, they - in practice and the heat of the moment - will choose not to whether due to mis-guidedness or because their flag has been captured by a rent-seeking constituency.

The Rioja Kid said...

Inflation isn't exogenous to the calculation of whether it's a liquidity crisis or a solvency crisis. The debts are nominal assets and collateralised against nominal assets. So it's more a case of the Fed having the ability to cause enough inflation to engineer the real economy back into solvency, via an inflation tax on debtholders.

I'm less sanguine on whether the March crisis was one of solvency rather than liquidity, but I wouldn't describe myself as "scared" of inflation - I want it to happen, because as far as I can see it's the medicine that gets straight to the cause of the problems.

狂猪 said...


This is the best analysis of the Fed's exit strategy that I've read. I have 2 questions.

1. Currently, there are some complaints from various emerging market central banks that the liquidity from the Fed is planting the seed of inflation in their local economies. This is happening even if inflation isn't a threat in the US. The argument centers around the dollar's role in global trade. However, I don't fully understand the argument. What is your take?

2. While the speed of the Fed's exit strategy should be naturally determined, what are some of the challenges / risks for the Fed to implementing it? Is it possible for inflation to set in before the public risk appetite returns? For example, since China is the world's factory, can a rapidly growing China ends up exporting inflation to the US?

Thank you for sharing your insights.

John Hempton said...

Once upon a time in Macroeconomics 1.01 and the old Aussie Nashnal Yooni I was taught that if you fix your currency you did not have an independent monetary policy. The monetary policy was to fix the currency.

If countries that are not hyper-inflated insist on fixing their currency to the US then they get the US monetary policy for better and for worse.

Ditto Spain and Germany etc...

But then I am not saying anything about fixed currencies that is nto patently obvious...


But What do I Know? said...

Nicely laid out argument/summary. The only sticking point is that the Fed continues to accumulate MBS precisely because no one else wishes to buy/hold them at these prices. Therefore, "the speed [that] the general public wants to hold mortgages and other risk assets again." is zero--at these prices--even with ZIRP.

Therefore, to determine the "natural" speed at which the general public will want to hold mortgages again, the Fed would need to stop buying and let MBS rates rise to their "natural" level. This they seem unwilling to do, since they believe (probably correctly) that higher rates would crush the housing resale market. And so there is no exit.

To me, the Fed seems like the guy desperately trying to defend a price while the other market participants are stuffing him with the asset and happy to get out at his expense--as in the denouement of an attempted market corner. The attempt to support asset prices usually fails because the defender runs out of money or balls. By definition, the Fed can't run out of the former--the real question is when (if) they run out of the latter.

JeffC said...

If the Fed's new assets turn out to be worthless, there's still an exit strategy. First, recapitalize: the US Treasury issues long-term debt to the Fed in exchange for shares, a next exchange of air for air. The taxpayers give up nothing, since the Fed policy of rebating net profits to the Treasury means negligible interest is actually paid on US debt held by the Fed. Second: the Fed sells the T-bonds into the market to sop up reserves in the normal way when they need to shrink the money supply. The net effect in the markets is that cash/reserves is replaced by long-term debt.

maff said...

You say that the banks will buy back the assets they exchanged with the Fed. Wouldn't they be better off, come the good times, keeping the cash and leveraging it up at 10-1 (or whatever they can get away with under Basel-n)?

EconomicDisconnect said...

I loved this working title so much I used it myself last week in a similiar discussion about the FED ending the MBS Purchase program in March:
or Tiny URL:

Myself, being a tin foil hatter and of the solid belief that no bank will want to buy back any major amount of the damaged loans pools think the easy breezy tale you tell will not happen. Of course we only have to wait until February to find out; the FED will expand the MBS buys again or they won't. Expansion means nobody wants this stuff after 2 years; ending the program will finally price them to market. We shall see some answers at that time. Your take on things is well written, but we just disagree 100%. Have a great Holiday.

Robert in Chicago said...

I second Cassandra's comment. You have explained why the Fed _can_ exit sufficiently to avoid high inflation. We have a large share of our fund's capital in inflation-sensitive assets because we believe the Fed _won't_ do so. Whether or not the banking system was insolvent, the problem in March was "too much debt" held by banks, corporations, and households. Now the government has shifted part of the problem onto itself; it is on a path towards a literally unsustainable debt load. The only resolutions to this problem are debt destruction (bankruptcy) or inflation. For the leaders of a debtor government who are elected by debtors and bankrolled by those who most benefit from asset inflation, the incentives to choose inflation are overwhelming. Our "independent" Fed has shown itself to be not so independent, and its leader has said over and over that he will err very, very strongly on the side of inflation.

Anonymous said...

so . . .if it s liquidity crisis- and it takes 20 years for the "assets" on the Fed's books to regain their value- is it still a liquidity crisis?

just wondering

Jeremy said...

but only if the asset side of its balance sheet is solid

So, you actually believe those MBS and Agency debt the Fed bought are actually worth anything? The GSEs are not illiquid, they're insolvent. Same goes for the MBS. Prime mortgages are defaulting at an historical rate, and each of those defaults are being papered over with money that cannot be withdrawn.

David Pearson said...


I believe the banking system does not need those Excess Reserves to extend credit. In a target-rate system, the Fed will supply an unlimited amount of (Required) reserves to keep the Fed Funds rate from rising above target. So, the banks are indifferent to a Fed that withdraws Excess Reserves but maintains ZIRP -- the banks just borrow back, as a system, as much as they want at no cost to support their desired credit growth.

The "Exit Plan" must also include moving away from ZIRP. Is this what you have in mind? If not, do I have the mechanics of rate-targeting wrong? Of course, the Fed could also pay a higher rate on Excess Reserves, but that effectively raises the policy rate as well -- same result.

Another way to think about it is to examine these two statements:

1) With ZIRP, the Fed will support an explosive growth in credit by making unlimited reserves available at zero cost.

2) With $1tr in ER's, the Fed will support an explosive growth in credit by allowing the banks to use their enormous excess reserves at (virtually) zero cost.

What is the difference between each?

Anonymous said...

Question from an economic ignoramus. The US dollar seems to be on a steady downward curve. Given that the US is indeed a part of a global economy, aren't gold and silver good hedges against the dollar's declinining purchase power?

Charles Butler said...


It gets real easy at some point, that being the normalization of mortgage delinquency rates (even possibly at historically high levels). Mortgage backed paper will fly out the door paying less-than-you'd-expect regard to ltv's.

Banks have no trouble moving inexpensive (to them) covereds in Spain despite widespread, and not entirely justified, doubts as to the credibilty of the value portion of the ltv calculation.

Keep up the liquidity/solvency stuff. You're right.

bleichröder said...

don't overestimate paul krugman's intelligence... his early work on trade and agglomeration is valuable but his recent media commentary has been inane and logically inconsistent.

I think there are a couple issues that aren't getting enough attention in this debate. I cover both to an extent on my blog.

as much as everyone talks about higher real rates, I think higher nominal rates owing to an increasing reluctance to fund the yawning deficit are just as if not more possible. Then again, the interest rate cycle has been strongly benign since the early 80's so not so surprising. Very few involved in markets today remember sustained higher rates. This will be ST painful but LT beneficial for the US- if you look at Japan, I think low yields are probably what will ultimately have been responsible for killing the country.

and don't underestimate the ability of the congress to make the Fed's job almost impossible.

Anonymous said...

John: Remember the Fed didn't buy them outright - Feds assets are collateral for the loans to the banks. Do you think when time comes and Fed loans mature or when Fed starts to "exit", the banks will walk away and ask the Fed to keep the collateral, because the collateral is worth nothing? I doubt the banks can do the "jingle mail" with the Fed. Even if you assume the banks were insolvent in Mar 09, don't you think the banks would have earned/raised equity enough to repay the Fed and thus avoiding the problem of Fed getting stuck with "worthless collateral".

狂猪 said...

Hi John,

Thanks for pointing me to Nashnal Yooni. My training is in computer science and I only got interested in economics because of this recession. I'll definitely read up on Yooni.

To your point about Spain and Germany, this is precisely the scenario that I am worried about. Similar to the different pace of recovery of Spain and Germany, China's economy could over heat while the US is still climbing out of the recession. If China over heats, the cost of production in China will go up in RMB. Because of the RMB to dollar peg, the price of Chinese good will also go up in dollar terms. This could than result in higher inflation in the US. On a side note, I would think without the peg the dollar price of Chinese goods could go up even more (in affect China is subsidizing it's export sector and the US consumers with the peg). At any rate, the questions are these.

Can the massive liquidity from the Fed somehow find it's way into China (and other emerging markets) ? Furthermore, can inflation in China lead to inflation in the US due to the import of Chinese goods?

Regarding independent monetary policy, I could be wrong but I suspect the idea that "if you fix your currency you did not have an independent monetary policy" applies to China. I think this only applies to countries with a relatively open financial system. China's financial system isn't open. China, instead of adjusting interest rates, it employs other means to control the liquidity in it's economy. For example, it sets annual lending quotas for all banks operating in China. I think China has been affective in controlling the supply of money in it's economy.

What do you think? Anyway, I haven't been able to fully grasp this stuff. Thanks again for sharing your thoughts.

gulkan said...

Let's say the risk assets on the Fed's balance sheet need to be written down by an average of 1/3rd before the private sector is willing to buy them back. How does the exit work in that case?

Clayton said...

Risk assets are not homogeneous, preference selection matters. Why would a market participant seeking to maximize returns purchase an asset that was unloaded on the fed (and there is an abundant supply of)when i could be chasing the next hot thing, be they commodities, Brazilian reals, korean baseball cards, or whatever? That excess money can move to alot of places and cause alot of damage before it makes its way back to the fed.

Anonymous said...

John, are you of hte opinion that there has not been a huge appetite for risk assets for the last 6 months? Thre appears to be an enormous appetite for risk asstes, jsut not the ones the Fed owns.

Anonymous said...


Even if the banks are all insolvent and march wasn´t just a liquidity crisis (I am not convinced of this) inflation may not happen. The debt destruction through default on a gargantuan scale that general bank insolvency implies will imo destroy broad money on an equally massive scale and almost assure deflation. The Fed´s creation of bank reserves is far too small to offset the debt destruction. I think the inflationistas are overlooking this. Even if they are right on the banks inflation is likely not to happen.

TheDrugsDontWork said...

I'm not an economist but I see inflation as a bottle neck. When a bottle neck is hit for a multitude of products - but demand is reasonably inelastic for these products - you get inflation or stagflation. The producer can’t make more money by selling more units because of the bottle neck so the only way to improve margins is to increase price.

Isn't it possible inflation could be triggered not by the FED but another oil shock, for example?

(What happens if India went to war with Pakistan? All of a sudden we would be short call centre staff and inflation for call centre skills would take off – you think I joke, well maybe I do)

It is therefore still possible to get inflation and at the same time for these FED mortgage assets to stay low in value. In that situation then the FED would have to raise interest rates to combat external inflation.

I'm thinking what impact it would have on the yield curve and F&F income statement.

The FED must pray that the world becomes benign and inflation doesn't get imported into USA. If it does then the MBS ont their balance sheet may not just devalue (as they pay fixed coupons) but their duration will surely increase? I may be muddling up CDO’s and MBS here.

Will Benny B suddenly feel his hands tied if China exports inflation and not deflation to the world?

Will he keep one eye on his balance sheet rather than raising interest rates?

Personally I fall into the deflationist camp but I thought I’d put a weak counter argument up.


On a tangential theme; what about dollar pegged currencies (similar to Dubai). Surely there are companies who don’t hedge their Dollar exposure but will be hopelessly exposed if their country suddenly releases the peg.

How would I go about finding such a company? Where should I look? Sorry being a bit cheeky.

May be I should be looking for companies in America who trade only with pegged currencies and have lazily not hedged?

Anonymous said...


I think inflation is not an easy concept, and therefore such mutually exclusive alternatives you suggest, does not exist.

Inflation is about expectations, perceptions, compensation by employees, capacity utility, import prices, and is not just a simple correlation with money supply.

You need demand for credit also, and you need banks that want to lend. The increase in money supply helps out, because interest rates are low, but does not mean people or corporations spend like there is no tomorrow.

Foreign central banks worry, because with the low rates in the US, the money that is unwanted in the US finds its way into high yielding countries, and increase money supply there, and in these places there are demand for credit and banks willing to lend.

It was both a solvency crisis and liquidity crisis that reinforced each other, by lowering asset values.

The FED can by law not take risk, so they have full backing by risk-free collateral.

Is there any losses, it will be picked up by taxpayers, and paid for by higher taxes, lower public spending, or both.

Only if the FED finance these losses, by buying GOV bonds, they will later on risk influence the markets and peoples inflation expectations, when the economy recovers. Say FED buys GOV bonds each year to finance Medicaid, because Congress will not increase taxes or raise fees to pay for it, this will be inflationary, but not if the once every 50 years, buy GOV bonds to avoid a market panic.

I think only a fool wants to vote for higher inflation, since higher nominal interest rates will follow, on the long term money, and this will have huge negative impact on asset values.

Residential and commercial asset values will plummet.

In short, a) yes it was both a solvency and liquidity crisis that reinforced each other and any support given not recovered by the TSY/FED will probably not lead to increased inflation expectations b) we need not worry about inflation other than in Gold and other speculative assets because of the easy money. Foreign central banks should worry though to stop the flow of short term hot money going into the system.


Anonymous said...

The initial "event" was liquidity driven, as in borrowing short and lending long and being unable to roll debt.

The Fed has plugged this (by printing).

The other outstanding issue is that the US deficits are unfundable except via the FED printing.

So the solvency issue applies to the US,
not the Fed (at least not to the Fed if it didn't print).

The Fed can't "unwind" without some other entity taking on funding the US deficits...

Aidan Neill said...

Very well balanced discussion, to which I would have to completely disagree - the assets that the Fed has taken on are worth less than the liabilities that go with. It is an insolvency issue...liquidity was the short-term answer so that we could prevent a disorderly insolvency. That has been achieved, but the system is still insolvent. We will have inflation because the government/ Fed will keep these assets "alive", when they should be dead.

Good Point said...

I don't believe Krugman, not for a second. The guy is like those climate scientists who were 'caught' in England.

Go back and read what he was saying about the US deficits in 2003 & 2004 (which I was inclined to agree with). Consistency and integrity are not his middle name.

GS751 said...

We won't know if it was a true solvency crisis for many years to come or until we see what path home prices and asset prices for that matter take.

Baconbacon said...


"First, recapitalize: the US Treasury issues long-term debt to the Fed in exchange for shares, a next exchange of air for air. The taxpayers give up nothing, since the Fed policy of rebating net profits to the Treasury means negligible interest is actually paid on US debt held by the Fed. Second: the Fed sells the T-bonds into the market to sop up reserves in the normal way when they need to shrink the money supply."

You contradict yourself here. If the Fed holds the T-bonds and gives the interest back to the treasury then it can't also sell them on the market. So this would cost the taxpayer.

Secondly, and more importantly, we are discussing the prospect of the fed fighting inflation. If inflation returns what happens to the yield on Treasuries? What happens to the yield on Treasuries if the US government adds $1 trillion worth to the supply? The average maturity for government debt is ~50 months which is extremely low (and a record low for the US I believe) and the US is scheduled to roll over > $1 trillion in debt a year BEFORE any deficit spending for the foreseeable future. Adding a large enough sum of debt to this mound in an effort to sterilize inflation would during a period of investors returning to risk assets would drive prices through the roof.

Fungus the Photo! said...

If inflation comes along, I will be gobsmacked, but fiscal policy: more taxation will cure that. As the assets are worthless, there will have to be some recapitalization of the banks at some stage, but to a far smaller degree given the capital destruction still raging. The amalgamation path of the FDIC is creating monster banks who really really really cannot be allowed to fail, but in the end will, Japanese style, until there is another war. I vote therefore for Japanese style deflation and as the USA $ is shall we say, overstretched and gold reserves may have been plundered, it will be an interesting time for nuke armed gringoes.....

ANU Australian National University Nasnul Yooni.......

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