James Pethokoukis

Politics and policy from inside Washington

Will the Fed need (gasp!) a government bailout?

January 11, 2011

Interesting piece from Team Reuters that examines that possibility (and what it really means) as a result of all the central bank’s asset buys (bold is mine):

But the Fed’s newfangled policy steps and the potential for credit losses raises, for some experts, the prospect that the Treasury may actually be forced to “recapitalize” the Fed — economist-speak for what others might call a bail-out. That would be a strange role reversal given the Fed’s efforts to ease monetary policy by buying the Treasury’s debt, and it could raise a political firestorm from lawmakers who believed all along the Fed was putting taxpayer money at risk. …¬†Varadarajan Chari, an economics professor at the University of Minnesota and a consultant to the Minneapolis Fed, says that at some point during its exit from easy monetary policies, the Fed actually may go broke — at least on paper.¬†”The most obvious exit strategy is, when inflation starts to pick up, to stop and reverse asset purchases,” he said. “That’s likely to include requiring the Fed in an accounting sense to see a significant accounting loss.”

The Fed now holds just over $1 trillion in Treasuries, Chari noted, and if inflation rose by a couple of percentage points, it would dent the value of those holdings by about 10 percent, leaving the Fed with a $100 billion loss. “I’m sure it will have some negative political fallout,” Chari said. “But not economic consequences. Their ability to print money means it (insolvency) doesn’t mean anything.”

The problem lies in the basic workings of fixed income. By definition, bond prices decline when their yields or interest rates go up. That means that as the economy recovers and pushes inflation higher, the Fed will move to increase interest rates, pushing down the value of its giant bond portfolio.¬†“What would the international reaction be if the Fed suddenly had to go and be recapitalized?” said Bob Eisenbeis, chief monetary economist at Cumberland Advisors and a former head of research at the Atlanta Fed. “I don’t think that would bode well for Treasuries, or for the dollar, or anything else. It would be embarrassing.”

Eisenbeis is right. If and when this happens, the financial nuances will certainly get lost and give plenty of additional ammo (not that they need it) to the anti-Fed movement.


Comments

Maybe the IRS could use a bail-in in the form of a voluntary tax that repays if the economy improved to a level that protects national security – ability to transfer debts to a guarantee note to share risk and reward specific shared goals if attained where downside simply confirms a more aggressive natural devaluation.

Posted by phyvyn | Report as abusive
 

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