What Henry Blodgett and Institutional Risk Analyst Don't Get About the Fed

Henry Blodgett has a reasonably sound post, Brace For Hyper-Inflation.

In the post he writes:

The economy is cratering, so the Fed is printing money. When the Fed prints money, this eventually produces inflation (more dollars, same amount of goods).

Ben Bernanke assured us yesterday that, this time, the Fed's money-printing won't eventually lead to inflation because the moment the economy begins to recover, the Fed will stop printing money and start burning it. Specifically, the Fed will start selling assets instead of buying them and thus shrink the money supply.

Unfortunately, Ben is unlikely to keep this promise.

So far, so good.

Then Blodgett lists the reasons Bernanke is likely to not keep his promise:

First, it will be hard to confidently assert that the economy in full recovery. Remember, in 2007, Ben (and most other people) thought the economy was in great shape as far as the eye could see. He and most other observers missed that disastrous turning point. So why do we think he'll correctly spot the next one? Especially because, if he blows it by jacking up rates too early, he'll kill the recovery.

Second, there will be intense political pressure to MAKE SURE that the economy is in rip-roaring health before hammering consumers and businesses by raising interest rates. Everyone loves low interest rates. And they'll only stop screaming about your taking them away when they're fat and happy (which will be long after inflation really gets going).

Third, the US government desperately needs low interest rates to fund its soon-to-be-monstrous debt load, so there will be another source of pressure on Ben to keep rates low. When we finish with all this stimulus, we're going to owe a boatload of money. We're really going to allow our Fed chief to send interest rates to the moon and jack up our refinancing costs?

All strong reasons, but then Blodgett writes:

Fourth, many of the assets that Bernanke has been buying to print money won't be easy to sell. This time around, the Fed isn't just buying easy-to-sell Treasuries. It's buying trash mortgage assets, et al. To reduce the money supply, it will need to sell them to someone. But who?...In the latest issue of the Institutional Risk Analyst, Chris Whalen hammers this last point home...But it's not only the size of the balance sheet that is so daunting; it's the makeup that's becoming truly scary. (Blodgett then quotes Whalen. Whalen's comments are below in italics)

Historically speaking, the composition of the Fed's balance sheet has been mostly Treasuries. And the Federal Open Market Committee would typically raise rates by selling Treasuries from its balance sheet into the market to soak up excess liquidity. However, because of the Fed's decision to purchase up to $1 trillion in Mortgage Backed Securities (and other unorthodox holdings), it will not be selling highly-liquid US debt to drain reserves from banks. Rather, it will be unwinding highly distressed MBS and packaged loans to AIG.... That means when it finally decides it's time to fight inflation, the Fed will find it much more difficult to reverse course.

Bernanke is in a major bind and it will be difficult for him to get out of it, but the technicalities of shrinking the balance sheet won't be a problem, as I have pointed out numerous times, the Fed is attempting to seek from Congress the authority to issue debt.

The main purpose for the Fed's desire to issue debt is so that they can drain reserves from the system without having to sell the toxic junk they have been buying.

San Francisco Fed president Janet Yellen has recently confirmed my analysis.

It should also be noted that the Fed has even another method to drain reserves. That is buy having the Treasury issue debt and then have the Treasury keep the proceeds on deposit at the Fed, which would drain reserves.

All this said, even the top quality Fed and Treasury credit that could be used to drain funds, will cause severe problems for the economy as it will result in pushing rates higher and also crowd out private sector borrowing. It is, thus, going to be an even bigger mess than Blodgett and Chris Whalen of Institutional Risk Analyst envision. Think stagflation on steroids.

The toxic assets the Fed is acquiring will be a major part of the problem, but the problem will manifest itself in more Treasury debt, and possibly Fed debt, being issued. This will be occurring at a time the Fed is trying to slow money growth down, which means they won't be buying the debt, and by then it will even be obvious to the Chinese that buying more US government debt is a death trap. Think interest rates climbing as if they were on steroids.