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John Carney, writing in
The Business Insider, questions the Fed's ability to shrink its expanded
monetary base to avoid a major inflation. "One of the sources of the
growth of the monetary base has been the $1 trillion of purchases of mortgage
backed securities by the Fed. . . Much of it
is on deposit with the Fed itself, where banks can earn risk-free interest
instead of lending it to home buyers at risk of losing their jobs or
businesses still suffering from diminished consumer demand."
When bank lending starts to accelerate, the Fed will have to withdraw those
funds by finding market buyers for them.
The
market’s knowledge that the Fed has become a seller rather than a buyer
for mortgage backed securities will likely result in the pricing of these
securities falling. In order to bring the yield of these securities up to a
level acceptable to the market, they will have to be sold at a discount. This
discounting means that the Fed will not be able to withdraw as much liquidity
as it added, leaving some portion of that $1 trillion (plus its multiplier
effect) in the economy to create inflation.
Think of it this way. If the Fed bought a mortgage backed security for $100
but can only sell it for $90, there’s a 10% inflationary discount
occurring. Which is to say, the Fed’s MBS has inflation built right
into it. There’s no way out.
But suppose the
Fed tries to fight inflation by paying higher interest rates on bank deposits
at the Fed?
Right now the Fed
gets away with paying very little interest, since demand for loans is low and
lending risks are still perceived as high. But as opportunities in the
economy grow, the Fed will have to increase the interest rates to prevent
inflationary lending.
The higher rates from the Fed, of course, will cause political outrage.
Essentially, bankers will be able to make handsome returns by not lending to
businesses and consumers. It will be perceived—rightfully so—as a
super-perverse subsidy.
And those higher rates will make it harder to sell the mortgage backed
securities. The Fed will have to sell at even greater discounts, since
bankers would rather just earn interest from the Fed unless the discount on
the MBS—and therefore the yield—grows high enough. And, of
course, each discount makes the inflation-fighting impact of the
mortgage-backed-security sale less effective.
George F. Smith
Read his book : The
Flight of the Barbarous Relic
Visit his website
Read his blog
Also
by George F. Smith
George F. Smith is the author of The Flight of the
Barbarous Relic, a novel about a renegade Fed chairman and the editor of
Barbarous Relic.com.
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