Trade Protectionism Looms Next as Central Banks
By Ambrose Evans-Pritchard
The Telegraph, London
Sunday, February 24, 2013
Officials at the US Federal Reserve may be more worried than they have
let on about the treacherous task of extricating America from quantitative
easing. This is an unsettling twist, with global implications.
A new paper for the US Monetary Policy Forum and published by the Fed
warns that the institution's capital base could be wiped out "several
times" once borrowing costs start to rise in earnest.
A mere whiff of inflation or more likely stagflation would cause a
bond market rout, leaving the Fed nursing escalating losses on its $2.9
trillion holdings. This portfolio is rising by $85 billion each month under
QE3. The longer it goes on, the greater the risk. Exit will become much
harder by 2014.
Such losses would lead to a political storm on Capitol Hill and risk a crisis
of confidence. The paper -- "Crunch Time: Fiscal Crises and the Role of
Monetary Policy" -- is co-written by former Fed governor Frederic Mishkin, Ben Bernanke's former right-hand man:
It argues the Fed is acutely vulnerable because it has stretched the
average maturity of its bond holdings to 11 years, and the longer the date,
the bigger the losses when yields rise. The Bank of Japan has kept below
Trouble could start by mid-decade and then compound at an alarming pace,
with yields spiking up to double-digit rates by the late 2020s. By then Fed
will be forced to finance spending to avert the greater evil of default.
"Sovereign risk remains alive and well in the U.S, and could
intensify. Feedback effects of higher rates can lead to a more dramatic
deterioration in long-run debt sustainability in the US than is captured in
official estimates," it said.
Europe has its own "QE" travails. The paper said the ECB's
purchase of Club Med bond amounts to "monetisation"
of public debt in countries shut out of global markets, whatever the claims
of Mario Draghi.
"We see at least a risk that the eurozone
is on a path to become more like Argentina (which of course is why German
central bankers are most concerned). The provinces overspend and are always
bailed out by the central government. The result is a permanent fiscal
imbalance for the central government, which then results in monetization of
the debt by the central bank and high inflation," it said.
In America, the Fed would face huge pressure to hold onto its bonds
rather than crystalize losses as yields rise -- in other words, to recoil
from unwinding QE at the proper moment. The authors argue that it would be
tantamount to throwing in the towel on inflation, the start of debt monetisation, or "fiscal dominance." Markets
would be merciless. Bond vigilantes would soon price in a very different
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