The Federal Reserve's Dilemna

THE FEDERAL RESERVE’S DILEMNA

In the fall of 2008, the Federal Reserve, in conjunction with the United States government and practically every developed nations’ government, took extraordinary measures to prevent what they thought would become a meltdown of the world’s financial system. Part of the Federal Reserve’s mission was to clear our financial system of toxic or troubled assets. These assets were not performing and essentially not worth any money (foreclosed mortgages, mortgage-backed securities, loans that were in default).

In a dramatic move, the Fed began the Troubled Asset Relief Fund (TALF) to go in and buy up these bad assets in exchange for cash to give banks a fresh start on their balance sheets and keep the financial system solvent and liquid. To date, the Federal Reserve has purchased over $1 trillion in troubled assets. Now, how does this create a dilemma?

In order to purchase these troubled assets, the Fed needed to create (print) one trillion dollars. So, in exchange for highly illiquid and worthless assets, the Fed pumped one trillion dollars into the economy. The problem is not just the inflationary risks of pumping the money into the economy, it’s in the eventuality that this money must be withdrawn.

The withdraw process will begin when the Fed stops buying toxic assets sometime before spring. Then, as the economy recovers, the Fed hopes that these assets will become worth something. As the valuation of these assets increases, the Fed can begin selling them back to the financial system in exchange for cash. That cash will be money that comes straight out of the economy, designed to counter-balance the inflationary pressures that the huge infusion of funds created.

The Federal Reserve will likely face economic variations in 2010 that will make monetary and troubled asset decision making tough in 2010.

For example, how dependant is the economy on the Federal Reserve’s TALF program? Some may argue not much, since the credit markets have not shown improvement since the fall 2008 financial bailout. However, if the economy was helped by TALF, it will certainly hurt as the Fed goes to sell these toxic assets back to the private market in the future.

First, can the Fed sell these toxic assets? While some firms are demanding toxics assets, there is some doubt that the private market will ever want these assets back. This doubt can be exacerbated by the fact that it appears the Federal Reserve overpaid for those toxic assets. But, let’s assume that the Fed can sell all of the toxic assets. In order to do so, the Fed must take money in exchange for these assets, thus decreasing the supply of money. This will lead to higher interest rates, and if the economy is not recovering, could lead to a longer recession.

Next, what if the Fed can sell some, but not all of the assets? This creates an inflationary problem because this means that money pumped into the economy is going to remain larger over the long-term than the money that is going to be pulled out. This leads to a weak currency, high commodity/import prices, and a decrease in consumer spending as consumers are forced to convert to more expensive alternatives, which create less economic value for the economy. This problem is worse if the Fed chooses not to sell any assets (or is unable to).

The Federal Reserve says it has an “exit strategy,” but it is very vague and ambiguous (some are almost certain that a strategy has not been agreed upon or put into writing). Even in an Op-ed in the Wall Street Journal, chairman Bernanke stated “accommodative policies will likely be warranted for an extended period.” In the same paragraph, he added “as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road.” Bernanke hits in the article that inflation could be a problem and notes that two key strategies for taming inflation will likely be implemented together, although historically one or the other had been used exclusively (paying interest on reserves and actions to reduce stock of reserves).

The Fed is going to have to thread the needle and sell the toxic assets without dramatically raising interest rates in the private markets, and if it waits too long, it’s going to have to fight inflation while also managing critical credit market components. There are even more questions about TALF, which are pointed in this video by the head TARP.

That begs the question, will the organize that totally missed the mark on the financial crisis, be able to see the signals of higher interest rates or inflation?

See a member of the Fed’s board’s presentation on an exit strategy