Mt. Vernon Register-News

Opinion

November 15, 2013

Handcuffs for Fed tighten with fiscal profligacy

(Continued)

As a point of reference, the Fed earned $41.5 billion in interest on its securities portfolio in the six months ended in June and paid $2.3 billion in interest on excess reserves.

Bernanke’s announcement in June that the Fed would refrain from selling its holdings of mortgage-backed securities reduced some of the concern about portfolio losses and prompted some staff economists to revise their projections of Fed earnings. They now expect annual remittances to the Treasury “to remain elevated by historical standards through 2015,” declining to a low of $17 billion in 2018, close to the $25 billion average in the decade before the financial crisis. Cumulative remittances from 2009 through 2025 should exceed $900 billion.

In January, the economists had projected unprecedented losses and no profits for the Treasury for up to six years.

The Fed could have mitigated balance-sheet losses by sticking to its traditional operating procedure of buying short- term securities: expanding the balance sheet without increasing interest-rate risk. But as Bernanke explained in December 2008, the focus of monetary policy was shifting to the asset side of the balance sheet, not the liability side. P, the price of long- term bonds, became more important than Q, the quantity of money created though purchases.

The potential bookkeeping loss is actually a small part of the story. The bigger issue is one that was described in a February 2012 paper (revised in July) by economists David Greenlaw, James D. Hamilton, Peter Hooper and Frederic S. Mishkin: “Crunch Time: Fiscal Crises and the Role of Monetary Policy.”

“Fiscal dominance forces the central bank to pursue inflationary monetary policy even if it has a strong commitment to control inflation,” the economists said. “Ultimately, the central bank is without power to avoid the consequences of an unsustainable fiscal policy.”

I asked Hamilton to outline a scenario under which monetary policy would be subjugated to fiscal policy. Here’s what he said. Congress fails to take actions to address the U.S.’s long- term fiscal imbalances. Confidence in Washington fades. The Treasury holds a bond auction that is undersubscribed, leading to a spike in interest rates.

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