Ben’s Balance Sheet Blues

europac.net / By Peter Schiff / Friday, March 1, 2013

During his testimony before Congress this week, Federal Reserve Chairman Bernanke made it a priority to dampen the growing concern that the unprecedented growth of the Fed’s balance sheet presents great risks to the economy. There has been a heightened sense even among normally complacent members of Congress that the Fed could spark a precipitous decline in the economy and the financial markets if and when it seeks to “withdraw liquidity” by selling even a minor portion of its bond portfolio (which is projected to swell to $4 trillion by year end). This is a valid concern that I have been discussing for years.

Gentle Ben soothed these fears by his novel assertion that the Fed doesn’t actually need to sell bonds to neutralize previously injected stimulus. Instead, the Fed could simply allow its bonds to mature, thereby achieving a more natural, and potentially less disruptive unwinding of its gargantuan portfolio. Although his explanation seemed to satisfy many of the Congressman (and the vast majority of the journalists who slavishly dote on Bernanke’s assurances), the idea is completely absurd.

As a result of its previous efforts during “Operation Twist” (which was conducted in order to push down long-term interest rates), the Fed has already swapped hundreds of billions of dollars of short-term securities for Treasury bonds with maturities of ten years or longer. Only a small portion of the Fed’s portfolio, then, becomes due at any given time. The average maturity of the entire portfolio is now over 10 years. There may well come a time when inflation or asset bubbles become so pronounced that aggressive withdrawal of stimulus is needed. Forceful action will only be possible through active selling, not simply by passive maturation.

However, either approach will be insufficient to tighten policy without a simultaneous cessation of buying of newly issued Treasury bonds. After all, to shrink the size of its balance sheet the Fed must stop adding to it…or at least add less than it is subtracting. Even if the Fed had the luxury of holding its bonds to maturity, such a stance would not prevent a collapse in the bond market. The Treasury does not have the cash needed to retire maturing bonds if the Fed stops rolling them over. As the government will have to sell the new bonds to other buyers, one way or another additional supply is going to hit the market.

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