Bernanke expressed confidence in his Jackson Hole speech, Monetary Policy since the Onset of the Crisis, that the Fed can “exit smoothly” when it wants to:
The FOMC has spent considerable effort planning and testing our exit strategy and will act decisively to execute it at the appropriate time.
In The Dilemma of the Impatient Trader, traders wishing to acquire or divest large positions quickly pay a premium for their impatience equal to the spread between average purchase and average sell prices minus the market bid/ask spread. Any exit strategy by the Fed must include the divestiture of their large securities position. This would begin if and when the economy were heating up and needled to be slowed. It might also become necessary if inflation takes off driving interest rates up. These would not necessarily be mutually exclusive scenarios.
From a balance sheet perspective, the cause of the exit is unimportant. What happens is the Fed sells securities to primary dealers (PDs) who pay for them from their excess reserves on deposit. These reserves were created by the Fed’s initial purchases of securities from the PDs. But the PDs are patient traders and the Fed is an impatient trader. The cost to the Fed, as its assets approach zero through sales, is the premium they paid on acquisition plus the premium they pay on sales. This means the PDs have a net balance left equal to this total premium. This is the money given to the PDs for their assistance in implementing Fed policy.
To balance assets and liabilities in true accounting fashion, the Fed’s capital position goes negative and the Fed becomes insolvent. Before this happens, however, by recent arrangement with the Treasury, the Treasury will backstop (bailout) the Fed.
The monetary base is considered the base of the money supply in the economy and is known as money with zero maturity. It is roughly the sum of the reserves on deposit with the Fed plus currency in circulation. Many have argues that if the excess reserves, currently standing at about $1.5 trillion, enter the economy, large scale inflation will result. The caveat has been that the Fed could unwind its balance sheet. But as we have argued, it can’t entirely. The trading premium incurred will remain as a liability after assets are gone. It will also remain as part of the monetary base and the Fed cannot do anything remotely orthodox to fix this. The result: built in inflation.
So welcome to Hotel California where any central bank can check in but it can’t check out.
It is always gratifying to get confirmation of our thinking from people much smarter and informed than we are. Today we got this eletter from Bob Eisenbeis, Chief Monetary Economist of Cumberland Advisors: We’ll Know It When We See It! These people understand the Fed, Fed operation and policies, and debt and bond markets as well as anyone and better than most. Bob wrote:
Certainly, the materials provided imply a long period of sustained asset acquisitions and a further substantial increase in the Fed’s balance sheet. This expansion will only exacerbate the Fed’s exit problem, and to the extent that it experiences capital losses on asset sales, those losses will accrue to the taxpayer through reduced remittances to the Treasury, and increase the deficit.
The “capital losses” are what we described as “premium paid” in The Dilemma of the Impatient Trader.