22 Apr 2009

Will New Fed "Tools" Avert Hyperinflation?

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My sources say no. An excerpt:

For a different idea, economists Woodward and Hall think the Fed just needs the ability to charge banks for holding reserves….How does this avert the threat of hyperinflation? Simple, according to Woodward and Hall. If banks ever start loaning out too much of their (now massive) excess reserves, and thereby start causing large price inflation, then the Fed can simply raise the interest rate it pays on reserves. Banks would then find it more profitable to lend to the Fed, as it were, rather than lending reserves out to homebuyers and other borrowers in the private sector. Voila! Problem solved.

Obviously these tricks can’t avoid the consequences of Bernanke’s mad money printing spree. At best, they would merely push back the day of reckoning, while ensuring that it grows exponentially (quite literally).

A quick numerical example: Let’s say the Fed wants to drain $100 billion in reserves out of the banking system, in order to cool off rising prices. But it doesn’t want to sell off some of its assets on its balance sheet (like “toxic” mortgage-backed securities), so instead the Fed sells $100 billion worth of the brand new “Fed bonds,” as Yellen hopes.

In the beginning, this will indeed solve the problem. When people in the private sector buy the Fed-issued bonds, they write checks on their banks and ultimately those banks see their reserves go down at the Fed. There is less money held by the public, and so prices don’t rise as quickly.

But what happens when the Fed bonds mature? For example, if the Fed sold a 12-month bond paying 1% interest, then after the year has passed our private sector buyers will hand over the securities and now their checking accounts will be credited with $101 billion. At that point, the economy would be in the same position as before, only worse: there would be an extra billion in newly created reserves (because of interest on the Fed debt).

Incidentally, the Daily Reckoning doesn’t do hyperlinks, so here are some of the things I relied on for the article:

* The CBO analysis of Obama’s 10-year budget plan,

* The CBO’s forecast in 2001 of $5.6 trillion in surpluses over the next decade,

* Janet Yellen discussing Fed debt as as “exit strategy,”

* Woodward and Hall discussing positive and negative interest on reserves as a way to avoid hyperinflation.

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