Thursday, August 19, 2010

Fed to lose control of interest rates in the USA?

An interesting article comes from the Wall Street Journal, Online Opinion, this morning which may be read in full from here. The main thrust is in this short quote: Between August and November 2008, the Federal Reserve swelled its balance sheet to $2.2 trillion from $940 billion to ease a potentially catastrophic credit crunch brought on by fears of cascading defaults. The assets added to the balance sheet are today comprised overwhelmingly of mortgage securities. The purchase of these securities had the parallel purpose of shoring up a collapsing housing market. Much of the money the Fed conjured to buy these assets made its way into reserves, which the banks chose to hold at the Fed. Excess reserves—reserves held above and beyond what the Fed requires of the banks as a minimum—soared to more than $1 trillion from $2 billion. As long as this money remains parked at the Fed, it poses no risk of fuelling inflation—just like cars parked in garages can't tie up traffic. But at some point the banks will muster the courage to begin transforming these near zero-yielding reserves into credit, and the Fed knows it then will have to act to prevent exuberance from pushing up prices too far and too fast—in traffic terms, to stop the cars from streaming onto the roads all at once. I recommend reading the article through to its conclusion which seems to me to correctly state: None of this matters a lick at the present moment, with inflation barely perceptible, credit weak, and banks happy to earn infinitesimal returns on their reserves. But it does suggest that the Fed's exit strategy is not credible, and that means a serious risk of high inflation down the road.



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