Ben Bernanke Has the Fed In Uncharted Waters

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In medieval times mapmakers used the phrase "Here be dragons" to denote dangerous or unexplored territory. That pretty much describes the journey Ben Bernanke is taking the Federal Reserve on these days. Monetary policy is in uncharted waters.

Now he's a good mariner, has studied the historical charts (especially the Great Depression), and has a lot of experience, but one does wonder if he is pushing things too far. After all, the economic crisis in America is over and things are getting back to normal, albeit slowly. Why the need for continuing such an extraordinary and risky policy?

The Federal Reserve's balance sheet is exploding as doses of quantitative easing are trying to counteract tightening fiscal policy (actually less simulative would be a better way to say it) and short term rates constrained by the "zero bound."

The Fed has purchased roughly one-half of all Treasury debt issued since 2009 and the weighted average maturity of its burgeoning portfolio has more than doubled to over 10 years. This year, the Fed could very well buy more government bonds than the Treasury issues!

The Fed itself believes that long rates are about 1% lower than they otherwise would be as a result. Stocks and housing prices have rallied on the idea of low rates from now until kingdom come. Hooray for the "wealth effect," although it does seem unfair that stock holders and debtors are making out like bandits while savers are being "financially repressed" and footing the bill.

And it makes one wonder if you shouldn't just spend, spend, spend and enjoy the good life by saving nothing. Just throw yourself on the mercy of the government in retirement and vote to get your "fair share" from the wealthy suckers who are savers. But I digress.

So far the Fed has been able to ride the yield curve and earn "profits" for the U.S. Treasury totaling $89 billion last year. At some point they are going to need an exit strategy or else they run the risk of rates rising and their "arbitrage" going upside down. If you hold the bonds to maturity to avoid losses more than likely you are going to produce a negative "net interest margin" at some point. The average coupon on their holdings is under 4% so it doesn't take much of a jump in short term rates to erase that margin.

The Federal Reserve knows all of this of course and in a recent working paper (The Federal Reserve's Balance Sheet and Earnings: A primer and projections) purports to analyze the various exit strategies from quantitative easing, basically concluding "nothing to see here, move along." In all seriousness, the stress tests are weak. The Fed would never accept these from a bank. And the use of a deferred asset account as a claim on future Treasury interest payments instead of booking losses to the capital account seems sketchy; GAAP or no GAAP. And the $250 billion of unrealized losses under one baseline scenario never hits the income statement because, well, they are unrealized and assumed to be held to maturity.

All of these Federal Reserve machinations remind me of John Law and his Mississippi scheme way back in 1720. Recall the French government was running out of money (sound familiar?) and Law's Mississippi Company agreed to take over the debt in return for monopoly trading rights. Law also managed to start a bank, to make loans (to facilitate purchase of Mississippi stock) and print paper money.

Needless to say the Mississippi scheme ended in a bubble that eventually burst. In the aftermath fiat money in France was discredited as a medium of exchange for decades.

The Fed does not see the potential costs of extraordinary monetary policy as outweighing the benefits of promoting a stronger economic recovery. But perhaps they are fooling themselves because we are talking about the haze of uncertainty here, of unknown unknowns, not probabilistically determined outcomes.

At this point if you are somewhat confused and apprehensive, that's a good thing. Stay on alert. As they say in Alaska, icebergs are much bigger than what you see on the surface.


Jeff Pantages, CFA, is the chief investment officer for Alaska Permanent Capital Management. 

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