Robert Murphy has written another great article, this time on the Fed and quantitative easing.  In the latter half of the article, he describes a black swan scenario where price inflation all of a sudden gets out of hand. I want to focus on one particular part of his article.  It is something that I’ve written about before.

Towards the end of the article, Murphy states,
“The problem is that Bernanke is sitting on huge piles of US government debt, which have just gotten decimated in the bond market. For example, if Bernanke in 2010 had created $1 billion of new reserves by buying $1 billion in additional Treasury debt, those securities would now be worth (say) only $650 million. So even if Bernanke sells them all back into private hands, he will only be able to eliminate 65 percent of the new reserves he had earlier created. Open market operations will not allow him to drain the system.”


This is what I discussed in the past with mortgage backed securities.  If the Fed bought all of these mortgage backed securities back in 2008 to bail out the banks and the Fed paid the original value of these things, what happens when the Fed tries to sell them?  After all, a lot of these mortgages have gone bad.  We hear about the horrible housing market and all of the short sales and foreclosures.  So let’s say that all of these mortgage backed securities are only worth half of what the Fed actually paid for them.  If high price inflation becomes a problem and the Fed tries to sell these assets, they will only be able to sell them for half of what they paid.


Just for example, let’s say the Fed paid $1 trillion for mortgage backed securities.  Now the Fed sells these and can only get half or $500 billion for them.  What happened to the other $500 billion?  That money is already in the system.  The Fed can’t soak it up.  It has no exit plan.  All it can do at that point is prevent future monetary inflation.


The only other possibility is forcing the banks to buy them back for the original value.  But why would the Fed do this when one of its main unstated purposes is to prop up banks?  Also, this would severely weaken the banks and could cause banks to fail.  Then the FDIC would have to bail out depositors and the Fed would have to bail out the FDIC.  This would defeat the original purpose of trying to soak up the excess money in the system.  Therefore, this is an unlikely scenario.


I don’t think the Fed would intentionally cause hyperinflation.  The bankers would be destroying themselves.  The fear that I do have is that they somewhat unintentionally destroy the dollar.  They think they can pull back at any time, just as Volcker did in the late 70’s and early 80’s.  But based on the discussion above, it may be impossible for the Fed to soak up all of the excess money once price inflation becomes bad.  If Bernanke and the Fed really do have an exit strategy, I sure would like to hear what it is.