26 Mar 2009

Worried About Inflation? Just Let the Fed Float Its Own Debt

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I tease him a lot, but Robert Wenzel is right when he gloats that he has been blogging about the real reason the Fed wants to issue debt. (I recall much more pedigreed economists being baffled by the Fed’s request.)

So anyway, SF Fed Bank President Janet Yellen confirms Wenzel’s theory: The Fed wants to issue debt in order to suck reserves out of the system without having to wreck the mortgage-backed securities or Treasury markets. I didn’t see the connection with the Fed issuing debt, but–if you’ll permit some horn-tooting–I have been saying for quite some time that Bernanke has painted himself into a corner. Once price inflation really kicks in, he will have to suck reserves out of the system. But if the CPI starts blowing through the roof while the banks are still crippled and unemployment is still high, Bernanke will be reluctant to unwind all the life-support propping up MBS and keeping Treasury yields low.

So the “solution”? The Fed can sell its own IOUs to the public. So if you buy a note from the Fed promising you $10,000 in 2015, you write them a check today for it (for less than that, of course, to give you interest) and when the Fed processes the check it drains reserves from your bank.

I hope no one thinks this is a solution to the problem. Almost literally, what it does is shift (say) 10% inflation this year to (say) 15% inflation in two years. Unless of course the Fed just allows its debt to grow exponentially, which it probably will do.

The only way this can even work in theory, is if it buys the Fed enough time for the markets to recover so that selling off the MBS and Treasury bonds when the Fed notes come due, is more feasible. But if things continue to deteriorate–and if you don’t believe they will, I would like you to tell me what else the government would need to do and promise to do, in order to make you pessimistic–then we will be in the same spot in two years, except the Fed will now have an additional trillion dollars in new reserves it is supposed to pay out to its noteholders. Oops.

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