Ben's Balance Sheet Blues
During his testimony before Congress this week, Federal Reserve Chairman Bernanke made it a priority to dampen the growing concern that the unprecedented growth of the Fed's balance sheet presents great risks to the economy. There has been a heightened sense even among normally complacent members of Congress that the Fed could spark a precipitous decline in the economy and the financial markets if and when it seeks to "withdraw liquidity" by selling even a minor portion of its bond portfolio (which is projected to swell to $4 trillion by year end). This is a valid concern that I have been discussing for years.
Gentle Ben soothed these fears by his novel assertion that the Fed doesn't actually need to sell bonds to neutralize previously injected stimulus. Instead, the Fed could simply allow its bonds to mature, thereby achieving a more natural, and potentially less disruptive unwinding of its gargantuan portfolio. Although his explanation seemed to satisfy many of the Congressman (and the vast majority of the journalists who slavishly dote on Bernanke's assurances), the idea is completely absurd.
As a result of its previous efforts during "Operation Twist" (which was conducted in order to push down long-term interest rates), the Fed has already swapped hundreds of billions of dollars of short-term securities for Treasury bonds with maturities of ten years or longer. Only a small portion of the Fed's portfolio, then, becomes due at any given time. The average maturity of the entire portfolio is now over 10 years. There may well come a time when inflation or asset bubbles become so pronounced that aggressive withdrawal of stimulus is needed. Forceful action will only be possible through active selling, not simply by passive maturation.
However, either approach will be insufficient to tighten policy without a simultaneous cessation of buying of newly issued Treasury bonds. After all, to shrink the size of its balance sheet the Fed must stop adding to it...or at least add less than it is subtracting. Even if the Fed had the luxury of holding its bonds to maturity, such a stance would not prevent a collapse in the bond market. The Treasury does not have the cash needed to retire maturing bonds if the Fed stops rolling them over. As the government will have to sell the new bonds to other buyers, one way or another additional supply is going to hit the market.
The Federal government is projected to run trillion dollar deficits for years to come. To cover that gap, the Treasury will need to continuously sell new bonds. This need will persist regardless of the Fed's policy priorities. For the last few years the Fed has been by far the biggest buyer of Treasuries, in recent times sucking up more than 60 percent of the total issuance. According to some reports, the Fed is expected to buy up to 90 percent of Treasuries in 2013. The only other significant buyers are foreign central banks (who buy for political reasons) and nimble hedge funds. Who does Bernanke expect will fill his shoes when he stops shopping?
To answer that question you must consider the economic environment that would compel the Fed to tighten in the first place. Presumably a period of accelerating economic growth, surging inflation, or rising interest rates would trigger asset sales. In such a situation, who in the world would want to buy low-yielding, long-term government paper while inflation is surging, the dollar is falling, and interest rates are rising? With the Fed on the sidelines, such an investment would be a guaranteed loser. Bernanke claims that the financial conditions will be soothed by an aggressive communications campaign that would let market participants know, in advance, precisely how the Fed intended to dispose of its assets. The cardinal rule in investing is that big players never telegraph their intentions. Fed "transparency" will simply mean that the hedge funds now making money by getting in front of the buying will be making even more money by getting in front of the selling! There will be no cavalry of new buyers riding to the rescue.
This means that any attempt to tighten, no matter how passive, will result in a significant drop in the price of U.S. Treasuries and mortgage-backed securities. Not only would this inflict massive losses to the value of the Fed's balance sheet but it would exert enormous upward pressure on interest and mortgage rates that the Fed will be unable to control.
In addition to his absurd "let them mature" gambit, Bernanke also announced other novel policy tools that will supposedly help him orchestrate a successful exit strategy, most notably raising the rates paid on funds held at the Federal Reserve. Such a move is expected to deter banks from lending into a surging economy or to invest in risky assets by enticing them to park cash at the Fed. But how high must these rates go, and how much would it cost the Fed (in reality U.S. taxpayers) to do this effectively? Given how high I believe inflation will become, these payments could be truly staggering. The net result will be a substitution of large operating losses for large portfolio losses (which would have come from bond sales).
As I have said many times before, the Fed has no credible exit strategy. Its portfolio is far too large, and the economy, the housing market, the banks, and the government, are far too dependent on ultra-low interest rates to allow Bernanke any real options. In truth, his only exit strategy is to just talk about an exit strategy. Bernanke's contention that the Fed need not sell any of its bonds is the closest thing yet to an official admission of this fact. Not too long ago Bernanke made the absurd claim that his intention to sell the bonds on the Fed's balance sheet meant that he was not monetizing debt. How times have changed.
Bernanke is banking on the hope that his policies will jump start the economy which will then be able to motor along on its own. However, the current era of cheap money and fiscal stimulus will never create an economy that is capable of standing on its own legs. Instead, it is propping up a parasitic economy that is completely dependent on the very supports the Fed believes it can one day remove. But if the Fed does not remove them on its own, the markets eventually will.
Bernanke also defended himself against some members of Congress, particularly economically savvy New Jersey representative Scott Garrett, who pointed out the hypocrisy of Bernanke's claims that Fed policies are responsible for the recent rise in home prices (while simultaneously absolving the Fed of any responsibility for rising home prices during the real estate bubble). To justify this claim, Bernanke made the self-serving distinction that while the Fed is currently purchasing mortgage-backed securities (in order to lower mortgages rates and boost home prices), no such actions existed prior to the 2008 financial crisis. As a result, he claims the Fed could not have been responsible for the bubble. On this point he is dead wrong.
Fed policy during the mid-years of the last decade had an enormous effect on mortgage rates and home prices. By holding short-term rates too low for too long, the Fed was responsible for the proliferation of Adjustable Rate Mortgages and the popularity of the ultra-low teaser rates without which the housing bubble never could have been inflated so large in the first place.
In other words, the Fed broke it then, but it sure can't fix it now.