Steil and Swartz: Fed’s exit strategy is not credible, and inflation is coming one way or another
The Wall Street Journal today contains an interesting Op-Ed from Benn Steil and Paul Swartz, both of the Council on Foreign Relations, regarding what the Fed’s options are for controlling runaway inflation. It’s worth reading in its entirety, but a couple of concepts are particularly important.
First, Steil and Swartz point out that the central bank’s balance sheet has more than doubled from $0.94 trillion to $2.2 trillion during the late, unlamented banking crisis. In the interest of upping the available credit to the market, the Fed bought securities and thereby released more cash into the system. These securities make up the increase in the balance sheet.
What happens when the Fed releases cash into the system through its purchase of securities in the marketplace? Generally credit expands and inflation follows the increase in money supply. Inflation tends to follow because the money is more or less printed and forced into circulation – to use Steil and Swartz’s term, it’s “conjured.”
So why haven’t we seen inflation yet? In a nutshell, banks are holding the excess cash at the Fed:
Much of the money the Fed conjured to buy these assets made its way into reserves, which the banks chose to hold at the Fed. Excess reserves—reserves held above and beyond what the Fed requires of the banks as a minimum—soared to more than $1 trillion from $2 billion.
Why would banks want to hold 500 times more money than normal in excess reserves at the Fed? Simply because the Fed is paying them to. So we’re in a situation now where the money supply has been bloated well beyond the normal printing activities of the central bank, but that money hasn’t hit the streets. This means we haven’t seen its inflationary effect. Yet.
Steil and Swartz give an indication of what’s going to happen next:
As long as this money remains parked at the Fed, it poses no risk of fueling inflation—just like cars parked in garages can’t tie up traffic. But at some point the banks will muster the courage to begin transforming these near zero-yielding reserves into credit, and the Fed knows it then will have to act to prevent exuberance from pushing up prices too far and too fast—in traffic terms, to stop the cars from streaming onto the roads all at once.
In normal times, the Fed would do this by selling Treasury securities from its balance sheet, which the banks pay for using the excess dollars they’ve parked in reserves. Those dollars are then no longer available to the banks to create credit.
But these are not normal times. The Fed doesn’t have an excess stock of Treasurys to sell—its holdings are at roughly what they were before the crisis. It has only a vast excess pile of politically toxic assets—the mortgage securities it has amassed since 2008. Dumping them would depress the housing market further by pushing up mortgage rates and enrage an already Fed-wary Congress.
Let’s recap. The Fed more than doubled its balance sheets with toxic securities and its only choices are:
- Sell the securities to mop up the extra money and prevent runaway inflation, which will result in the collapse of the mortgage market, or
- Keep the securities and prop up the mortgage market at an artificial level, which will result in runaway inflation.
So we’re damned if we and damned if we don’t. This, of course, raises the question of how we damned ourselves in the first place, and naturally a straight line can be drawn back to our own government policies.
There are various policies which have been adopted over the years to prop up the housing market – tax-deductibility of mortgage interest; government-backed loans to poor credit risks through the FHA; regulations forcing banks to lend to almost anyone who asks through the CRA; deadbeat relief programs that just result in massive redefaults, like HAMP and Hope for Homeowners; and ultimately the previously implicit, now very explicit, taxpayer guarantee of the mortgage market through Fannie Mae and Freddie Mac.
Our government was chasing an unrealistic version of the “American dream” all while assuming that, with enough government intervention, the housing market could be propped up forever. This kind of hubris is outrageous, but sadly, expected from a government that doesn’t know its limits. And finally, when the government reaches those limits, it’s the taxpayers who feel the pain. The only questions that remain are whether the pain will come through the collapse of the artificially propped-up housing market, or whether it will come through the rapid evaporation of wealth that inflation always entails.
These are questions that could have been avoided if the government hadn’t been involved in the first place.