Janet Yellen's Greatest Challenge

November 22, 2013

With the Senate Banking Committee on Thursday approving Janet Yellen's nomination to lead the Federal Reserve, her confirmation is virtually assured. Less certain is what Yellen ultimately intends to do with Fed policy on quantitative easing (QE), now entering its 34th month. She is committed to maintaining QE for now, but does she have an exit strategy? The Fed needs one, because the economic stakes could not be higher, say Thomas Saving, a senior fellow at the National Center for Policy Analysis and professor of economics and the director of the Private Enterprise Research Center at Texas A&M University, and Phil Gramm, a former chairman of the Senate Banking Committee.

  • If we listen to the Fed governors, the potentially explosive increase in the money supply inherent in the current $2.3 trillion of excess bank reserves won't be allowed to occur.
  • At the first sign of a real economic recovery, the Fed will sell Treasurys and mortgage-backed securities (MBSs) to soak up excess bank reserves, or achieve the same result through repurchase agreements and paying banks to hold excess reserves.

It sounds simple, but in a full-blown recovery the Fed will have to execute its exit strategy quickly enough to keep the inflation genie in the bottle without driving interest rates up to levels that would derail the recovery. And every month that the Fed's monetary expansion continues, its exit strategy becomes more difficult and dangerous.

  • To maintain the money supply's historic relation to gross domestic product, once a real recovery begins the Fed will have to start to divest its $1.4 trillion of MBSs -- about a quarter of all MBSs held outside Fannie Mae.
  • This would send mortgage rates spiraling, even if the sales were spread over several years.
  • Even if the Fed could sell its MBSs, absorb its losses and withstand the public outcry as mortgage rates soared, its work would not yet be finished.
  • The Fed would still need to move about $600 billion of U.S. Treasurys off its books to reduce excess reserves in the banking system.

Another complication is that the Fed does not mark its assets to market, meaning every increase in interest rates drives down the market value of its Treasury and MBS holdings and requires the Fed to sell more and more of the book value of its portfolio to lower the monetary base by the required amount, depleting both the Feds asset holdings and earnings.

There's also the problem of a strong recovery raising private demand for credit rapidly, pushing up interest rates and thus requiring the Treasury to pay out billions in additional annual interest. As the Treasury borrows to meet its interest expense and the Fed sells assets to soak up excess bank reserves, private borrowing will be crowded out and the recovery will start to crater.

Never in our history has so much money been spent to produce so little good, and the full bill for this failed policy has yet to arrive. No such explosion of debt has ever escaped a day of reckoning and no such monetary surge has ever had a happy ending.

Source: Phil Gramm and Thomas R. Saving, "Janet Yellen's Greatest Challenge," Wall Street Journal, November 21, 2013.

 

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