A picture is worth a thousand words? Here's one that's worth considerably more. How does
$2.3 trillion strike you?
What is this leaning tower of money? It's the balance sheet of the Federal Reserve. More exactly, it's the Fed's portfolio
A year ago it was about half this size. To give you some idea of how big it is now, it represents about 20% of the aggregate
balance sheet of the entire commercial banking system in the United States. There's never been anything like it.
And a year ago it was nowhere near this complex. Then it was mostly Treasury bills plus some outstanding repurchase agreements
(basically, temporary cash investments). But as the credit crisis began about a year ago, the Fed has developed an alphabet
soup of special liquidity programs.
For instance, those three components in the chart called Maiden Lane, Maiden Lane II and Maiden Lane III -- totaling $65
billion -- are portfolios of illiquid assets acquired by the Fed in connection with the collapses of Bear Stearns and American International Group (AIG1).
That big hunk called CPFF, worth $319 billion, is the Commercial Paper Funding Facility. It's a portfolio of commercial
paper -- very short-term bonds -- issued by various banks and other companies. After the collapse of Lehman Brothers, the
commercial paper market completely shut down, so the Fed created the CPFF to get it going again. At this point, for all intents
and purposes, the CPFF is the commercial paper market.
That huge $682 billion piece called "swap lines" is a portfolio of currency transactions the Fed has done with other central
banks around the world. To help them meet their emergency dollar-funding needs, the Fed has swapped dollars for European euros,
Japanese yen, Korean won, Brazilian real and so on.
When the FOMC met last week, the headline was that the Fed cut interest rates to near zero. But that wasn't the real story.
The Fed's interest rates have actually been near zero for most of the last two months. The FOMC just formalized it. The only
interest rate story from the FOMC was that it intended to keep rates super-low "for some time."
The real story from the FOMC was what it said about the balance sheet. It announced that it intended to keep it as large
as it is today for quite a while -- and, in fact, to look for ways to make it even larger.
The Fed announced last month that it intends to buy $600 billion of direct mortgage obligations from Fannie
Mae (FNM2) and Freddie Mac (FRE3) and mortgage-backed securities in the open market. Then the FOMC said that the Fed would be buying Treasury
bonds as well.
So don't be surprised that the yields of Treasury bonds have collapsed to lows not seen since the 1930s over the last several
weeks. And don't tell yourself it's because the bond market is expecting another Great Depression. It's all about the Fed.
The bond market knows now that the Fed is going to keep rates low and buy tons of bonds as well. Obviously yields are going
to plummet to levels seen 70-odd years ago when the Fed had very similar policies in place.
Among other reasons, the fact that the Fed is doing all this gives me confidence that the worst of the credit crisis is
behind us. All we have to worry about now is digging out of a recession. And we've done that before. It's not fun, but it
can be done.
But where does the Fed get the money to do all these things? Simple: It counterfeits it.
Well, I shouldn't really say that. It's perfectly legal when the Fed does it. But if you or I did the same thing, we'd
be thrown in jail. Let's just say the Fed prints the money. Or better yet, that the Fed creates it.
If your first intuition is that printing that much money will cause inflation, you're right. But it won't happen anytime
soon. Inflation doesn't happen just because the Fed prints money; it happens when the Fed prints too much more than the economy
Right now the economy needs the Fed's money. In the credit crisis, the economy needs plenty of money to keep markets liquid
or even functioning at all. So there's no immediate inflation threat. In fact, if the Fed weren't growing its balance sheet
as it is, there would be a deflation threat.
But let's keep our eye on things here. Even though it's the right thing for the Fed now, someday it won't be. Someday the
economy won't need as much money, and the Fed will have to start decommissioning its enormous balance sheet.
Will it be able to do it? Will it get the timing right? If not -- if the Fed errs on the side of caution and waits too
long to stop the money presses and run them in reverse -- then we really will have an inflation problem.
Maybe that's why of all the risky assets in the marketplace, gold has done the least badly. It's down 15% or so from its
highs earlier this year, but compared to everything else that's downright great performance. Maybe the most inflation-sensitive
commodity is guessing that eventually the Fed just won't be able to resist an inflationary mistake.
The bottom line is that the Fed is going to extremes, because desperate times call for desperate measures. Bravo to Ben
Bernanke for showing the courage and creativity to do it.
But nobody's perfect. I'm buying a little gold, just in case.1