How The Fed Plans To Unwind: Must Read

They’re not sure, really. We’ve got to pass the bill try the tricks to see what’s in it what happens.

First: They’re further expanding their QEFinity.

A decision by the Federal Reserve to expand its bond buying next week is likely to prompt policy makers to rewrite their 18-month-old blueprint for an exit from record monetary stimulus.

Under the exit strategy, the Fed would start selling bonds in mid-2015 in a bid to return its holdings to pre-crisis proportions in two to three years. An accelerated buildup of assets would also mean a faster pace of sales when the time comes to exit — increasing the risk that a jump in interest rates would crush the economic recovery.

“There is certainly an issue about unwinding the balance sheet” in a way that “is effective and continues to support the recovery without creating inflation,” St. Louis Fed Bank President James Bullard said in an interview in October. The central bank might have to “revisit” the 2011 strategy, he added.

So, the ‘plan’ (more of an idea, if you ask me) didn’t work. They decide that maybe they should increase their holdings (double-down!!!), since they are only the largest current holder US debt on the planet:

The Fed is already buying $40 billion a month in mortgage- backed securities to boost the economy, and policy makers meeting Dec. 11-12 will consider whether to purchase more assets. John Williams, president of the San Francisco Fed, has proposed adding $45 billion of Treasury securities a month.

The bigger the balance sheet, “the riskier the exit becomes,” Richmond Fed President Jeffrey Lacker said[...]

Finding Ways

(^^^ Inspires a feeling of confidence, doesn’t it?)
When simply buying the short-term treasury debt didn’t help, they staved off inflation by buying longer-term treasury debt and using it to replace the short-term stuff.

The central bank has been extending the maturities of its assets with Operation Twist, a program to replace $667 billion of short-term debt with the same amount of longer-term bonds that expires this month.(~nota note: If it sounds like they used a home equity loan to pay off their credit cards, that’s because that is essentially what they did.)

A decision to expand purchases could push the total assets to $4 trillion by the end of 2013, said Michael Hanson, a senior U.S. economist at Bank of America Corp. Total assets stand at $2.86 trillion, up from $869 billion at the end of June 2007.

“The more they add to the balance sheet, the longer it will take to normalize,” said Hanson, who worked on designing tools that will be used in the Fed’s exit strategy as an economist in the monetary affairs division at the Board of Governors in 2009. (‘normalize’ – read: ‘protracted recession’  & ‘tools that will be used’ – remember that above, they said they don’t know what they will do… just saying.)

[...]

Here’s where it gets interesting:

The Fed announced the exit strategy in June 2011 as it sought to assure investors that it had the means to avoid igniting inflation once job growth, wages, and demand started moving up. The plan was part of Bernanke’s push for greater transparency and predictability.

The goal is to return the balance sheet to a pre-crisis size in two to three years and eliminate holdings of housing debt “over a period of three to five years.”

First, the Fed would allow assets to mature without being replaced, a process that will be slower now that the Fed has extended the average duration of its holdings. It would then modify its guidance on how long it plans to keep the federal funds rate near zero and begin temporary operations to drain excess bank reserves.

The Fed would next raise the federal funds rate, and finally, it would start selling securities.

The balance sheet averaged about 6.3 percent of nominal gross domestic product during the decade before the financial crisis. Today, a balance sheet of that size would be around $995 billion rather than $2.86 trillion. (by Dec,2013 that 6.3% of nominal GDP will be 24%!!! )

“The exit is going to take a long time,” said Stephen Oliner, a resident scholar at the American Enterprise Institute in Washington and former Fed Board senior adviser. He estimates the Fed’s holdings could rise to more than $4 trillion. (The Fed is monetizing roughly half of the budget deficit next year.)

If the Fed were to start bringing its holdings back to their pre-crisis level today, it would have to sell almost $2 trillion over a period of two to three years under its current exit plan. Assuming holdings grow to $4 trillion, asset sales could come to $3 trillion over the same period.

Fed officials haven’t publicly discussed an alternative plan for shrinking the balance sheet. One possibility, said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, would be to enlist the help of the U.S. Treasury.

One-time Swap

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. (Yep. You read that right. They could use the Treasury to buy the long-term debt that they bought from the Treasury to exchange[sell] for the short-term debt that they bought from the Treasury. Like talking about time travel, isn’t it?)[they're using the paid-off credit cards to pay off the home equity loan...ugh.]

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.

Asset purchases have made it harder to change the federal funds rate when the time comes to raise borrowing costs.

In the five years before the crisis, excess bank reserves averaged $1.7 billion, so the Fed could alter interest rates by buying or selling comparatively small amounts of short-term debt in open-market operations.

Those reserves are now more than 800 times larger at $1.4 trillion. To move the fed funds rate, the central bank will have to drain or lock up the supply of excess reserves.

Current Plan

Under the current exit plan, the Fed would soak up reserves by using reverse repurchase agreements or offering term deposits.

“I’m not sure we’ll really know, until they undertake a real program, what the effectiveness is”[...]

The Fed’s other tool is to extinguish reserves by selling bonds back to dealers. Even a fully-explained plan could push up home borrowing (inflation) costs as traders account for hundreds of billions of dollars of new supply flowing back into the market.

“We are deep into experimentation at this point,” Oliner said. “It’s understandable that people are worried.”

Okay, why should you care about this? When the Fed decides it’s time to unwind their balance sheet, they will do so by removing 24% of nominal GDP from the system.

For those liberals who think GDP is the beat-all, end-all for econometrics, where does that leave growth? Kind of seems like the Fed and the Treasury have tied us in a bit of a Gordian Knot, in their quest for a painless recovery. Inflation will come (even more than we’re seeing now). It will hurt. Their financial circle jerk of using phony dollars to buy worthless debt and trade it again for worthless dollars will ultimately destroy any remaining credibility and faith in the US dollar.

Scary stuff.

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2 Responses to How The Fed Plans To Unwind: Must Read

  1. Greg B says:

    “-nota note” ha ha!
    Where do you come up with this stuff?
    That’s almost as good as “catastrophuck”
    :)

  2. Locke n Load says:

    Well, see, there’s a bit of a gaping hole in this plan. They can’t sell these bonds/notes on the open market as 1: they’re going to be holding more than 24% of GDP, they’re going to be holding about 90% of all outstanding debt at that point and BE the market into which they usually sell. 2: They will be competing against the Treasury sales for financing of our almost certain 1+_ trillion deficits.

    Now, as for 1, ask yourself what kind of market will exist for those sales? If the global market is drying up now for them, what on earth makes anyone think the market will somehow expand in an environment where the USG is STILL cranking out insane annual deficits, the Debt is over 19 trillion, and the US economy is laboring under Japanese style stagnation (at best!) while gold continues to make new highs further deflating the value of the dollars they try to hawk like vendors in some mexican beach town?

    Regarding 2, this scenario DEMANDS an extremely robust super-Reaganesque recovery that re-instills faith in the dollar. Without that there would be no reason for a recovery of the dollar’s value. Unless our economy goes into overdrive this option is total fantasy. We simply can’t sell enough bonds to finance a 1.5 trillion deficit while competing with our central bank attempting to unload almost equal amts. Who in the fuck thinks notes written against increasingly worthless paper would generate ANY demand? This stretches the idea of rehypothication to such absurdity it resembles a mobius strip. The system cannot eat itself like this and hope to retain any semblence of good faith from the buyers. Period.

    Long story short, the Fed has no option but to pray for a robust recovery spanning 20 years (ha!) and thereby roll out of the debt by actually letting maturities expire OR forcing their purchases into another pocket, say, private member banks. But since that last option is ALSO part of the problem (excess liquidity re above) thats not actually a viable alternative.

    The Fed is fucked right now but not completely dead, at least it doesn’t have to be. But in actuality it IS because they’re committed to continuing this absurd liquidity farce our annual deficits demand.

    And thats really the rub. We sinmply CAN’T begin to fix the problem until the USG stops spending 50% more than it takes in. Period, end of story.
    Wanna put odds on THAT happening?

    I’m sorry, I really am, but the only way out is complete devaluation and collapse as long as we continue down this deficit/debt path. World powers are already moving to drop the dollar which will only excacerbate the death spiral if not drop the guillotine on the neck of the economy.

    Catastrophuck indeed. Wish I could predict a better outcome but I can’t. At best they start forcing individual and institutional purchases of the deficit (like Japan which is indebted almost entirely to it’s citizenry). At worst, there’s a violent break and the system collapses before we kneel at the feet of the new world bank.
    Take your choice.

    The Treasury and Fed think they can operate in a world that will always DEMAND our debt. Thats a bad idea, epic bad. No demand, no dollar, no economy.

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