I talked to so many people today who were sure that the fed's move was a precursor to them raising the funds rate as a "next move"...

First of all, did anyone think the next move on FF would be anything other then a raise? Second, why would they raise rates? It isn't like there is rampant inflation in the system... and what inflation there is has nothing to do with monetary policy being too lose, in fact I would argue that money is actually pretty tight... This brings me to my next question, why are people afraid of the fed raising rates? I mean, if you are invested on the short end, and can't suffer any principle impairment I understand, but why are people so freaked out about the idea? I even had someone tell me today that people were borrowing money at low rates thanks to the fed, and that was what caused the rally in the market over the last ten months... I mean how cockeyed is that? Sorry to rant, but I get so tired of people who are scared from the 2008-2009 market running around like a bunch of chicken littles...

Don't even get me started on Peter Shiff...

Obviously there is no inflation because banks aren't lending right now. I still believe pressure not to lend is a sign that we still have too much insolvency in the system (if assets had to actually be marked to market). Was reading somewhere that all of the foreclosure flush will likely be finished within two years. At that point, the necessary marks will have been taking and I think banks will have more incentive to lend. That's when the inflation starts.

The looming questions: Can the Fed sell their MBS portfolio in two years (or whenever) without cratering the mortgage market too much? Near term, more importantly, will the mortgage rates not skyrocket without the Fed buying $10B-20B+ net/week of agencies? And if they do, does that extend the insolvency and economic malaise? All of the other policy ideas to suck money out of the system (interest on reserves increase, reverse repos, Fed CDs, etc.) all equate to higher Fed Funds. Then we have fiscal issues which create political pressure to keep Fed funds down. $180B of auctions next week, with $130B of debt maturing around the same period, creating net new demand for $50B of money to be sucked up by treasury - in just one week. We can't exactly afford an average cost of debt for the treasury govt to skyrocket to 7-10%, because suddenly debt service costs elevate to $1T/yr+ alone.

If I had to predict the path of least resistance, I say the Fed balance sheet stays near $2T (maybe gets cut to $1.5T when its already too late) and much of the present $1.1T of excess reserves eventually gets lent out. Which means a giant move up in the price level, weakening of the dollar, increasing nominal wages (probably decreasing in real terms), increasing money supply (which will in turn facilitate buying all this treasury supply at lower rates), and an increase of GDP to 30T/yr. During all of this, the Fed will attempt to counter (when its already too late) and more importantly temper expectations and convincing the market the inflationary move is a one time event. If they successfully temper expectations, they'll keep borrowing costs low while suffering the money supply ramp merely through the exchange rate mechanism. The perk there will be a new level of competitiveness on the global export stage.

OK that's how I view the chess board. I'd put 10% odds that the Fed manages to pull out the $$$ just in time. But timing this entirely hinges on when banks are collectively solvent again. Too bad all of these effects are self reinforcing, thus difficult to control (ie, if houses and commercial real estate doubled in price tommorow from a one time devaluation, suddenly every bank out there with a questionable book would be solvent.)

Well, I don't think the Fed is going to sell their MBS, the question about what will happen when they stop buying is a valid one, but I think they are going to hold the bonds they have bought. What time frame do you think your "path of least resistance" plays out in? I mean, that is a very large change in GDP... even if inflation were to go out to 5% it would take years to nominally inflate to that level... or do you see there being a large shift all at once?

jakedeez wrote:Well, I don't think the Fed is going to sell their MBS, the question about what will happen when they stop buying is a valid one, but I think they are going to hold the bonds they have bought. What time frame do you think your "path of least resistance" plays out in? I mean, that is a very large change in GDP... even if inflation were to go out to 5% it would take years to nominally inflate to that level... or do you see there being a large shift all at once?

Over the weekend I came across a Fed paper better explaining the interest on reserves policy. It then catalyzed me to do some analysis. It is attached - this is just a few hours of work and I'm not an economist, but if this holds up, then what you are saying is definitely true - the Fed will have no need to reduce the size of its balance sheet in order to maintain interest rate targets effectively, going forward. Take a look and post some thoughts.

I've thought it will be a rapid inflation event (maybe over several years), but perhaps my inflation views are changing because I am starting to think the Fed has better control over aggregate money supply than ever before.

The source Fed paper is linked in the front page of the PDF.