Behind the Fed's Desire to Issue Its Own Debt Obligations

Bob Murphy and I had an excellent discussion via email about the trap the Fed is in, given the huge amount of reserves in the system. Bob explains the trap, here.

The gist of Bob's analysis is that unless Bernanke wants to turn the United States inflation rate into a competitive race with Zimbabwe, the Fed is going to have to sell Fed assets to drain reserves at some point. The problem is that a large chunk of Fed assets are now junk CDO's and the like. Who's going to buy those?

And, then it hit me, the Fed wants to be able to issue debt so that it can drain reserves. Any money the Fed receives via the banking system to pay for newly issued Fed debt will be retired. Viola, extra reserves, poof, pow, gone.

Of course, that's Bernanke's model. Execution will be another story, given the amount of debt the Fed will have to issue to drain enough reserves. Excess reserves are currently over $500 billion.

A word of advice to the intellectually curious, don't die in 2009, it's going to be a very interesting year.