The Federal Reserve’s Delimma

The privatively owned Federal Reserve seems to have gotten itself into quite the financial box these days. By coming to the rescue of its Wall Street buddies the Federal Reserve has essentially put itself into the position that if we have any significant inflation, world economy heats up, investors sell out of bonds and invest significantly into commodities, the Fed will have to cut its profits by selling assets, reducing the monetary base, and driving up interest rates to “tighten” monetary policy and fight inflation. Maybe there is a loving God out there, maybe the Fed will go out of business. Only one problem, despite having no constitutional or congressional approval the Fed is making a special accounting line in its books to transfer the losses to the Treasury Department.

The following appeared in Hussman funds on 4-11-2011.

Charles Plosser and the 50% Contraction in the Fed’s Balance Sheet

John P. Hussman, Ph.D.
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Reprint Policy

The Federal Reserve choose to "drive" the economy as per Keynesian protocol and may end up someday paying the ultimate price for its foolishness

Last week, an unusual event happened in the money markets that should not escape the attention of investors. The yield on 3-month Treasury bills plunged to less than 5 basis points. As I noted this past January in Sixteen Cents: Pushing the Unstable Limits of Monetary Policy , a collapse in short-term yields to nearly zero is a predictable outcome of QE2, based on the very robust historical relationship between short-term interest rates and the amount of cash and bank reserves (monetary base) that people are willing to hold per dollar of nominal GDP:

“Barring external upward pressures on interest rates, a further non-inflationary expansion of the Fed’s balance sheet of $400 billion, to $2.4 trillion (as contemplated under QE2), would imply the need for 3-month Treasury yields to fall to just 0.05%. Higher rates would be inflationary, because monetary velocity would not be sufficiently restrained. In effect, a further expansion in the monetary base requires that short-term interest rates decline enough to ensure a significant drop in velocity.

Rest of article here.

This is so tragic but the bottom line is if we get inflation, and we will, the silver lining could be if congress can block taxpayers money going to the Federal Reserve to cover their losses we the people might be able to kill the third monopoly bank established in the United States. I know it is a dream but it is one hell of a dream.

On the flip side the Federal Reserve is hoping against all hope that there will be sluggish 3% growth well into the future and interest rates remain low. This is horrible news for the millions unemployed and for any Republican candidate that actually understands the economics involved. Someone like Palin who does not understand economics with the exception she hates government spending and loves drilling would be such a threat. Ron Paul, Gary Johnson if they had popular support. Whoever the economic candidate is that could actually stimulate the economy, and inflation, will be opposed by the Federal Reserve, Wall Street and of course the Washington crowd. The Federal Reserve could be wiped out in a instant if people became optimistic about future economic growth and inflation increased dramatically.

The other option for the Federal Reserve would be to go down printing its way out of insolvency and creating massive amounts of inflation making it the most hated institution in America. A startling option considering congress has a 10% approval rating.

Overall there may be a way for future politicians to end the Fed but it will come at a tremendous cost.