Monday, December 15, 2008

An Exploding Federal Reserve

The Wall Street Journal announced recently that the Fed is considering issuing bonds to the public. The story received media attention for about a day. It deserves more.

Here are the key facts: The Fed loaned more than $1.3 trillion of new money into the financial system since august (compare the August sheet to the current one), up from $0.9 trillion. This has caused a unprecedented increase in the monetary base. In normal times, this increase in money would immediately create high inflation. Thanks to a dysfunctional financial system and shrinking economy, the new money so far has had little effect.

However, if or when the crisis passes, the banks will function again and the velocity of money will rise. Then, all this money that the Fed has put out there will suddenly become inflationary. The fed will need a way to take all that money back out of the economy, and fast.

Currently, the Fed owns about half a trillion dollars of US treasury bonds. By selling these, the Fed can pull that much money out of the economy. But the Fed may need to pull out more than twice that much money by the time this is over.

To pull out that much money, one of two things must happen. Either the Fed must start issuing new bonds, which would require congressional approval, or the Treasury would have to issue bonds and loan the money raised to the Fed. But the Treasury is already doing this, and congress allows the Treasury to sell only so many bonds.

In summary, congress will have to expand the powers of the Treasury or the Fed in order to prevent a brewing mess caused by the actions of the Fed thus far. And they should increase the powers of the Fed in this case, rather than the Treasury, for transparency: If the Fed needs to issue new bonds, it seems somewhat convoluted to have the Treasury sell the bonds and then loan the money to the Fed.

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