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The Great Inflation Debate

September 8, 2009


The Federal Reserve responded aggressively to the economic crisis with unconventional monetary policy measures. These measures have vastly expanded the size of the Fed’s balance sheet, leading to concerns over future inflation. Chairman Ben Bernanke has argued that the Fed has the tools to fight any uptick in inflation; for example paying interest on reserves. But it is not only the size of the Fed’s balance sheet that has changed; its composition has changed as well. As the chart above illustrates, the Fed is now holding riskier assets, such as mortgage backed securities, that may prove difficult to unwind in a timely fashion.


Krugman: The Big Inflation Scare
Meltzer: Inflation Nation
Bernanke: Semiannual Monetary Policy Report to Congress
Economist: Inflation Is Bad, But Deflation Is Worse

Post a Comment 5 Comments

  • Posted by crazyhog


    Thank you for sharing this. I have a couple of questions.

    1. What is the composition of the hard to unwind risky assets? How does it compare with easy to unwind risky assets?

    2. Why is some risky asset hard to unwind? Are you worry that the Fed will be force to take a lost? Or are you saying the markets for these asset will not recover soon?

    3. What other option does the Fed have to neutralize these hard to unwind risky assets? For example, can the Fed reduce it’s holding of traditional assets to compensate?

    4. Is the Fed does reduce traditional asset holding such as treasury, does that imply higher long term interest rate?

  • Posted by crazyhog

    I’ve just looked at the following from WSJ.

    It would seem only the Mortgage Back Securities are hard to unwind. Other assets on the Fed balance sheet have already shrink a lot. To my earlier question, why some MBS are harder to unwind than others?

    Thanks again for sharing your thoughts.

  • Posted by Geographics

    1. The ‘hard to unwind risky assets’ are composed of Agencies, MBS, Credit to AIG, Term Asset Backed Securities Loan Facility, and the Maiden Lanes. The ‘easy to unwind risky assets’ include Term Auction Credit, discount window (primary, secondary, seasonal credit), primary dealer credit, asset backed CP facility, portfolio holding of Commerical paper funding facility, and central bank liquidity swaps.
    2. The breakdown was designed around which could be taken off at par relatively quickly. For example term credit could be withdrawn at 100 cents by not renewing the credit line, which could be done relatively quickly. If the Fed wanted to quickly shrink the balance sheet via the selling of MBS, they would have to find a buyer of the security (or asset) and the money that they pulled out of the system would be a function of the purchase price. We are not making an argument about potential losses on the monetary balance sheet which, if significant, would risk monetary management and political independence. We are also not making an argument about the possible performance of these markets. Our point is simply about the composition of the balance sheet and how it has changed. Although the growth rate has slowed, the composition is changing.
    3. The Fed has funded interventions since the balance sheet started to grow through reserve balance and supplemental treasury issuance. If banks drawdown their reserves, the Fed could keep their interventions sterilized by tempting those reserves back with reserve rate increases or through more supplemental treasury issuances. There has been some discussion about the Fed being able to issue its own debt. Selling off treasuries would be one way to shrink the balance sheet. The most recent Fed minutes suggest that they have considered a number of different ways to handle the balance sheet (on page2).
    4. There is some empirical research that touches on this question done by Hubbard and Engen (2004).
    The sign for monetary authority purchases is intuitive, but I wonder about marginal sector elasticities. If the monetary authority wasn’t buying the debt, who would have to and what price would be needed to induce them. One can take a look at the Flow of Funds data to get somewhat of a picture about this question.

    Hope this help. Thanks for the comment.

  • Posted by Mike Laird

    Summarized, the trend has been and seems to continue to pump cash to problem banks in return for holding more and more of their illiquid, high risk assets. But the cash is “held prisoner” in the Fed’s Reserve balances (via interest paid to the banks) so it: 1. does not create inflation, and 2. does not get loaned to businesses. Sounds like a formula to create zombie banks and starve businesses that need loans. Or am I missing something?

  • Posted by Geographics

    The interventions have been sterile because the cash has, as you suggest, circled back to the Fed, although I suspect it is less because of interest being offered on reserves and more because they do not want to leverage up their balance sheet. Thus there is little creation of broad money, no spending from that broad money, no increase in capacity utilization and no inflation. But increasing cash in the banking system does not create zombie banks. The fact that the cash is not being used may reflect the degree to which banks are zombie-like (capital constrained). It is important to realize that there is a difference between being unwilling to utilize available capital (risk adverse) and being undercapitalized. The first can turn quickly; the second is a longer term problem. That said capitalization is a not black and white issue, but rather a matter of degree.

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