10 Dec 2012

The Fed’s New and Improved (!) Exit Plan

Federal Reserve 34 Comments

This Bloomberg article on the Fed’s possible need for a new “exit plan” is eerie; it is the financial analog of reading the NYT calmly discuss the Administration’s “secret kill list” (their headline).

When I read this, I was perplexed: ““They have to find ways of unwinding the balance sheet without dumping all of it in the marketplace,” said Memani… What does that even mean? How do you unwind your holdings of assets without selling them? I thought maybe Memani was just talking about the timing–letting the assets mature over time, rather than selling them upfront. And it does seem like that’s the plan, with a special twist (in fact a reverse twist):

The Fed could ask to swap longer-term Treasury debt for short-term bills and notes, thus reducing the maturity of its portfolio to accelerate the runoff. The Fed and Treasury could do this partly in a one-time swap, and partly by allowing the Fed to bid on new issues and pay with its holdings of long-term Treasuries, Crandall said.

Because the Fed would have less debt to sell to return its portfolio to a normal size, it could be “more aggressive in the liquidation” of housing-agency securities, he said, which was a priority for Fed officials when they announced the exit strategy.

I haven’t thought this through too carefully, but the above makes 0% sense to me. It’s similar to the platinum coin magic trick: The only way it “works” is if the Fed/Treasury take other offsetting actions that defeat the original purpose.

Can you guys spell out the logic of this proposal? I realize some of you may not endorse it, but perhaps you at least see the superficial thinking here.

34 Responses to “The Fed’s New and Improved (!) Exit Plan”

  1. Jonathan M.F. Catalán says:

    What I don’t get from that part you excerpt is that the first paragraph talks about short-term maturity treasury bonds, and then someone the authors argue that these have something to do with Fed holdings of MBS’. When the Fed says it’s worried about disrupting the MBS market by selling their holdings too aggressively, how will a reduction in the holdings of Treasuries help? Has the MBS market even started to recover? Right now, I figure that the Fed’s main problem is that the price paid for the MBS’ is much higher than the price they’re worth.

    • guest says:

      Operation Screw: The Fed goes all-in on QE

      Now, the FED also went on to say that, “Well, it’s not really spending because whatever financial assets the FED buys it’s going to turn around and sell back into the market when it unwinds the policy.”

      Yeah, right.

      How is the FED going to sell all these bonds? The FED is the only buyer. Without the FED, no one in their right mind is going to buy. Who’s going to buy when the FED wants to sell? Who’s going to step in front of that freight train?

      Who’s going to want to bid for mortgages when the FED is trying to unload the mortgages that it owns? Nobody.

      In other words, the FED has basically checked into the roach motel of monetary policy. Right?; It can check in, but it can’t check out.

      (It’s “Hotel California”, by the way.)

      • guest says:

        That’s a Peter Schiff video. Forgot to mention it.

  2. guest says:

    They’re hoping that the market will keep up with inflation if they unwind slow enough.

    That’s my understanding.

    But given how Cloward and Piven advocated getting as many people on government support as possible so as to collapse the system, it may be that the purpose of all the bond purchases was always to destroy the economy.

    Consider this:

    Occupy 2.0 : Destroy U.S. Economy with Lawlessness

    And keep in mind that the Occupy movement was started by the Marxists in SEIU:

    Who Is Behind the ‘US Day of Rage’ to ‘Occupy’ Wall Street this September 17th?

  3. Tel says:

    What does that even mean? How do you unwind your holdings of assets without selling them?

    In simple terms, it means they need a scam. A new scam. A better scam. A scam that no one has thought of before and no one will see coming.

  4. konst says:

    Basically all this Fed manoeuvring is an attempt to deny the fact that this whole financial mess is cause by the fraudulent practise of fractional reserve banking.

    What they’re basically saying to themselves is something like “How can we delude ourselves to ignore the fact that all this ‘wealth’ is based on fraud (leverage) and hope everyone else believes us?”

    The heart of the problem is a lot of people with political connections have an illusion of wealth on paper and they don’t want that fake non-real world wealth to disappear when reality (deleveraging) catches up with their delusions. Those with connections have the military to tell the rest of their peers that their wealth will be the last one standing in a global game of musical chairs with the losers face reality (the poor house).

  5. Transformer says:

    Here is my take:

    If the fed has to sell a bunch of bonds that it has on your books and wants to minimize the effect this will have on the money supply then it is better off selling bonds with short-term maturities because it will soon be able to pay out on them and get them off the books (and get the money back into the system).

    Looks like they are planning to convert some longer-term bonds to short term bonds to facilitate this , but not clear to me how that will work exactly.

    • Transformer says:

      “its books” not ” your books”

  6. xgsmmy says:

    I think this is similar to the platinum coin thing. Dean Baker has talk about this. The Fed could just hold on to their assets and since the Fed apparently refunds its “profits” to the treasury this would lower the debt burden. (I used to think that they still had to collect taxes to do this but apparently it’s an accounting thing.)

    Baker says if this is inflationary down the road they could slowly raise reserve requirements over time.

    I’m guessing the want to swap for short term debt because the public holding long term debt is easier to manage and gives them more control later.

    • xgsmmy says:


    • xgsmmy says:

      Oh, Dean Baker also picked up on the Ron Paul idea of the Fed destroying it’s assets as a way to get around the debt limit. That would seem to be similar to the coin idea.

      • skylien says:

        Only that Ron Paul suggested this as an ironic measure to show the craziness of the current system. That people like Dean Baker pick that up and think that is a great idea, just proves the point.

  7. Jordan says:

    It strikes me as a very odd proposal.

    The swap idea would “work” in terms of shortening maturities if the issues “swapped” are previously outstanding. Intragovernmental ST debt is swapped for the Fed’s LT debt, and boom, maturity shortened. Never been done before (I think) and very dubious, but I get the idea.

    His second option makes no sense to me, because it involves newly issued debt. How could the Fed bid directly on shorter-term Treasury issues and “pay” with its “holdings of long-term treasuries”? The Treasury issues debt to raise funds. Cash has to be given to the Treasury. The Fed cannot just bid on new IOUs with old IOUs because the Treasury would receive no funds and therefore a budget gap remains. The Fed could of course sell the LT treasuries and use proceeds to buy new ST treasuries, but this defeats the purpose of the author’s argument, as it sells bonds directly onto the marketplace.

    So I think outstanding debt has to be involved and not newly issued debt.

    In terms of analysis, I’ll take a shot at the “logic”. Assume all new government debt is rolled-over, i.e. no tax increases. The govt swaps its 1 year T bill with the Fed’s 10 year T bond. One year later, the govt raises $1000 to pay to the Fed. The Fed’s portfolio has now shrunk and the markets were only tapped for $1000. Without the swap, the Fed shrinks its portfolio by selling assets. The Fed sells its T-bond for $1000 but meanwhile the govt still rolls over its T bill by raising $1000. So in this case the markets were tapped for $2000.

    With the swap the Fed’s portfolio could shrink with less debt dumped on the market, so less risk of rates rising, more money in the system, blah blah.

    I guess that could make sense? Any errors you see just point ’em out.

  8. skylien says:

    Isn’t it strange that after they started operation twist in which they are swapping short term bonds for long term bonds to have stimulative effects by suppressing long term interest rates (and long term inflation expectations btw), that someone then tries to promote the opposite operation (reverse operation twist) that suddenly should have no anti-stimulative effect, hu?

    This sounds to me like a desperate drug user who is in denial about his own current state and tries to think of some magic tricks that will spare him the pain that inevitably will come sooner or later only to keep on taking higher and higher doses of drugs to overcome his depressions.. It’s all about flow… Keep the flow going.

    • Jordan says:

      If a reverse twist happened through the markets, then I’d agree it would have the opposite effect. But a direct swap of outstanding intragovernmental debt and Fed holdings would potentially avoid those effects. I’m not endorsing it though.

      • skylien says:

        Sorry I think you are wrong that this would avoid those effects.

        Imagine SS has a 2 year bond and the FED has a 10 year bond for swap of one billion face value.

        They swap those bonds. Now the FED decides not to buy a new 2 year bond when the old one is due and therefore it shrinks its balance sheet by one billion. SS has a 10 year bond.

        1: In case SS needs the 1 billion after two years now SS, instead of the FED, will sell it into the market and forcing interest rates up. If the Fed wants to avoid that, it will need to buy this 10 year bond worth 1 billion. So you end up where you started.

        2: In case SS wants to keep the 1 billion in form of a bond, then this would mean they will not sell the bond. However this also means if SS still owned the 2 year bond instead of the 10 year they would have to go to the market buying up another bond say a 10 year bond that is 8 years from maturity. This means had the FED not swapped its bond SS would have sucked up another long term bond anyway, which means the FED would need to buy up another long term bond in the swap scenario if it wanted to keep the long term interest rate unaffected compared to the scenario in which no swap would have been done and the FED had kept the long term bond on its balance sheet. Again you end up where you started.

        This is a shell game.

        • Jordan says:

          I see what you’re saying. I understand case #1. If SS needs the funds, then we agree. As for case #2, i think I understand.

          One question. In my example, I was assuming that the govt would voluntarily lengthen maturity in the interest of the Fed’s exit strategy. What if SS (or some other govt agency) doesn’t need the funds and it wouldn’t have lengthened maturity in the case of no swap. That is, with the swap, it holds the ten year. Without the swap, it doesn’t necessarily purchase an 8 year when the 2 matures.

          • skylien says:

            Hm, I am not sure I understand your question correctly. You mean that with swap it will keep the 10 year bond, but without swap the government will keep on paying interest on the 2 year bond even after it matures as if it was a long term bond?

            If that is the case then the government needs to increase the interest that it pays on the bond so that it fits the rates of long term bonds from the time it was issued, else the bond will probably go down in value and impair the balance sheet of SS.

            On the other hand technically I guess this would just like be a rollover of a maturing 2 year bond with a new long term bond. Instead of buying from the market SS would buy from the government. Yet in this case this just increases the amount of long term bonds in the whole market and will again push up interest rates of long term bonds compared to the scenario in which the government wouldn’t issue a new long term bond or how you called it voluntarily lengthen the maturity.

            • Jordan says:

              Sorry, have a hard time putting this in words.

              Say the swap described above happens. The govt holds the 10 year. The Fed holds the 2 year. When the 2 year matures, the govt issues new debt to pay off the Fed. It retains its 8 year.

              Would this strategy not “work” because new debt has to be issued, so the money supply still contracts and rates still go up?

              • skylien says:

                “Would this strategy not “work” because new debt has to be issued, so the money supply still contracts and rates still go up?”


                If the Fed shrinks its balance sheet, then interest rates will be affected to the upside. There is just no way around it.

  9. skylien says:

    An interesting article about interest on excess reserves, the M2 multiplier and spending “velocity” with good charts I did not see so far:


    I like the colorful way how he expressed the dilemma of the big FED balance sheet:
    “…And I think the Second Law of Thermodynamics (which says essentially that you can’t put the poop back in the goat) makes that optimism ill-placed. …”

  10. skylien says:

    You may think about Fama’s EMH this or that it nevertheless is interesting what he has to say about the FED’s balance sheet (I know it is confirmation bias, it is still nice to see that you are not alone with your opinion):

    Though I think there is a typo when he talks about the FED’s balance sheet. I guess he meant 850 billion not 150..

    Litterman: What impact will the big expansion
    in the Federal Reserve’s balance sheet have on the

    Fama: It has basically rendered the Fed powerless
    to control inflation. In 2008, when Lehman
    Brothers collapsed, the Fed wanted to get the markets
    moving and made massive purchases of securities.
    The corollary to that activity, however, is
    that reserves issued by the Fed and held by banks
    exploded. An explosion in reserves causes an
    explosion in the price level unless interest is paid
    on the reserves. So, the Fed started to pay interest
    on its reserves, which means that the central bank
    issued bonds to buy bonds. I think it’s a largely
    neutral activity.
    Before 2008, controlling inflation was a matter
    of controlling the monetary base (currency plus
    reserves). But when the central bank pays interest
    on its reserves, it is the currency supply that determines
    inflation. But banks can exchange currency
    for reserves on demand, which means the Fed cannot
    control the currency supply and inflation, or
    the price level, is out of its control. The Fed had the
    power to control inflation, but I don’t think it does
    under the current scenario.

    Litterman: How does that relate to the debt
    issues that the United States is facing?

    Fama: The debt issues are entirely different.
    The debt issues are about how much we want to
    sacrifice the future for the present and whether we
    get anything in the present for the future we’re sacrificing.
    This has been the big debate between the
    Keynesians and the non-Keynesians since 2008.

    Litterman: But isn’t one way out of our debt
    problem to inflate it away?

    Fama: Yes, that’s one way to handle it, but it’s
    far from a great solution. If the Fed were to stop
    paying interest on its reserves, we’d probably
    have a big inflation problem. The monetary base
    was about $150 billion before the Fed stepped in
    in 2008. Currency plus required reserves are still
    in that neighborhood, but the Fed is holding $2.5
    trillion—trillion!—worth of debt financed almost
    entirely by excess reserves. The price level could
    expand by the ratio of those two numbers, and that
    translates into hyperinflation. Economies typically
    do not function well in hyperinflation. The real
    value of the government debt might disappear, but
    the economy is likely to disappear with it.

    Litterman: What would your suggestion be for
    monetary or fiscal policy at this point?

    Fama: Simple. Balance the budget. I heard a
    very prominent person say in private that we could
    balance the budget by going back to the level of
    government expenditures in 2007. The economy
    is currently about the size it was then. If you just
    rolled expenditures back to that point, I think it
    would come close to balancing the budget.”

    Full interview here:

  11. Major_Freedom says:

    I don’t think there’s even going to be an “exit”.

    The treasury debt market is probably going to tumble because of the fiscal cliff, then humming and hawing, then “we must stabilize the financial system”, then more inflation, etc.

  12. Gamble says:

    Apparently the Bernanke has been reading Mises and came to the conclusion his damn will no longer hold back all the inflation and or mal-investment they created.

    In the past, they would have taken us to war in an attempt to clean up there mess that originated in the year 1913. Now they are toying with less violent options. Gotta give them some credit for tempting peace.

    IT is a little too late but Austrians need to do their best to explain the least troublesome exit strategy. Rather than rub it in, show them the way, understanding there will be some fiscal losers.

  13. Yancey Ward says:

    It’s purpose is to be incomprehensible. Bullcrap always tries to be incomprehensible.

    There never was an exit.

    • Gamble says:

      HI Yancy,

      What did G Edward Griffin say? Something about the Fed was never designed to provide clarity, rather obfuscation and deception.

      My earlier post was an attempt to put a good spin on a bad situation. Rather than remind everyone of the Feds true nature, I tried to rally the troops so they may write a proper strategy in unison.

      Sure Ayn Rand in Atlas Shrugged warned us by saying, “Unite and be conquered” but I think it would now be appropriate for all freedom lovers to bring forth the correct exit strategy. We don’t have to form a research committee, think tank, advocacy group or government, simply write and rebroadcast the correct strategy.

      Be done with it.

      • Tel says:

        I think the Libertarians have been saying for a long time that the correct strategy is for government to get smaller and not attempt to manage the economy.

        The problem being that most people like their big government for a whole range of reasons. Strangely they also seem to like the idea of uncompetitive markets. I still hear people complaining about the problem with Linux as an operating system is that there are too many choices. People seem to be happier when they get told what to do, and they love to get told that what they do doesn’t matter.

        Paul Krugman still gets probably 50 times larger readership than Bob Murphy… and most of those readers lap it up.

        We are on the rollercoaster now. It took several generations to get here, there’s no quick and easy escape from this.

        • Matt Tanous says:

          ” I still hear people complaining about the problem with Linux as an operating system is that there are too many choices.”

          Really? I always hear that it is too complicated. And, in many respects it is. It’s also generally a capital good, being developed by producers to meet their needs, not a consumer good like the Windows OS. Thus, the emphasis on the command line interface, and not the more eye-pleasing and simple GUI interface with heavy automation.

          • Matt G says:

            That is quite insightful. I wonder if the current state of FOSS development in general is suited primarily to the production of capital goods.

        • Ryan says:

          The problem with Linux is fragmentation. This is a totally different concept from having “too many choices.”

    • Ed O'Donnell says:

      If it’s purpose was to be incomprehensible, then it has failed. What I saw was crystal clear. The Fed is more or less admitting that it’s “exit strategy” is a steaming pile of bullcrap.

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