Greg Mankiw Finds a Time Bomb in QE2 that Could Get Bernanke Bounced

In a commentary on QE2, Harvard Professor and the world's greatest economcs textbook salesman, Greg Mankiw,  points out an interesting aspect of Bernanke's latest money pumping operation, namely, it could blow up in Bernnake's face. He writes about QE2:

Moreover, I do see some potential downsides. In particular, the Fed is making its portfolio riskier. By borrowing short and investing long, the Fed is in some ways becoming the hedge fund of last resort. If future events require higher interest rates, the Fed will end up making losses on its portfolio. And even if doesn't recognize these losses (by not marking to market), it could end up paying more interest on newly expanded reserves than it is earning on its newly acquired portfolio of long bonds. Such a cash-flow deficit could potentially undermine the Fed's political independence (which is already not very popular in some circles). Yet if the Fed tries to avoid these losses by failing to raise rates when needed, inflation could indeed become a problem down the road. I trust the team at the Fed enough to think they will avoid that mistake.

Now, Mankiw is a careful dude. He has a lot more textbooks to sell, so he is not going to ruffle any feathers. He will understate the situation. But, what he is saying here is that Bernanke may have just created the device that, at a minimum, may get him bounced as head of the Fed, or might even result in the end of the Fed, itself.

By Bernanke's combination of new tools and new methods, he has created a ticking time bomb. The key new tool is Bernanke's move to pay interest on reserves that banks have on deposit at the Fed. The key new method is Bernanke's move away from buying short-term Treasury paper and buying longer term.

Here's the problem as outlined by Mankiw.

Because of this new tool and new method, Bernanke has the Fed borrowing short-term and lending long. The Fed is buying Treasury securities of a longer duration than has been the practice. The money used to purchase the securities will show up as reserves at the Fed once the banks deposit the Fed checks. Bernanke is paying 0.25% on these reserves. That is he is "borrowing" the money from the banks.

At the same time, he is buying Treasury securities of longer duration that pay a higher interest rate. Current 5-year notes pay 1.49%.

If inflation heats up, the Fed will be forced to raise the rate it pays on the reserves, Bernanke said as much today in a speech in Germany:

The Fed's power to pay interest on banks' reserves held at the Federal Reserve will allow it to manage short-term interest rates effectively and thus to tighten policy when needed, even if bank reserves remain high.

But here's the ticking time bomb. If the Fed raises rates on those reserves in the future at some point short term rates could be higher than where current long-term rates are. Under this scenario, the Fed will start going cash flow negative on the bonds and notes it is purchasing now. The Fed could show an overall loss. Got that? The Fed, that can print money at will and has never had a loss in its history, could show a loss because of Bernanke's mad tools.

Mankiw knows what this means. Bye-bye Bernanke. Maybe bye-bye Fed. Mankiw, in his understated way, writes:

Such a cash-flow deficit could potentially undermine the Fed's political independence (which is already not very popular in some circles). 

Of course, the Fed could always keep the interest rate on reserves where it is, but Mankiw knows where this leads, and takes a subtle jab at Bernanke's team:

...if the Fed tries to avoid these losses by failing to raise rates when needed, inflation could indeed become a problem down the road. I trust the team at the Fed enough to think they will avoid that mistake.