A Fractious Fed?

By Doug Hornig of Casey Research

This coming Friday and Saturday, the Federal Reserve Bank of Kansas City will sponsor its annual retreat in Jackson Hole, Wyoming. It’s a chance for Fed officials, foreign counterparts, and academic experts to meet to discuss economic policy. This one could be contentious.

According to Jon Hilsenrath’s lengthy article in Tuesday’s Wall Street Journal, the last regularly scheduled meeting of the FOMC, on August 10, was the stormiest of Ben Bernanke’s four-and-a-half-year tenure as chairman.

At issue: what to do about the Fed’s huge portfolio of mortgage-backed securities that it accepted from ailing banks back in the formal bailout days. That portfolio is about to begin shrinking much more rapidly than anticipated, as low mortgage rates cause Americans to refinance their mortgages. Which means that securities held by the Fed are being paid off.

What’s the extent of the shrinkage? A group led by the New York Fed’s markets chief, Brian Sack, projected that the portfolio would contract by up to $340 billion by the end of 2011. In addition, it was estimated that about $55 billion in debt issued by Fannie Mae and Freddie Mac, and held by the Fed, would likely be paid off. Taken together, that represented a potential 20% drop in the Fed’s $2.05 trillion in holdings in 18 months’ time.

The options: allow the Fed’s balance sheet to shrink, which would amount to a passive tightening of financial conditions; or act aggressively to maintain holdings at the current level, i.e., continue down the easy-money path.

Most investors know that Ben Bernanke favored the latter. He got his way, as expressed in the FOMC’s formal decision to use the mortgage proceeds to buy Treasuries. The vote was 9-1, with only perpetual gadfly Thomas Hoenig of Kansas City dissenting.

But Hilsenrath notes that the seemingly substantial agreement disguises the lack of true consensus. Of the 17 attending – the FOMC consists of 5 Washington-based governors and the heads of the 12 regional banks, but only 10 have voting rights at any given time – he says that seven “spoke against the proposal or expressed reservations.”

Bernanke will have the opportunity to further define his position when he speaks at Jackson Hole, and he may introduce some fine tuning. Most likely, he will try to paint a big, agreeable smiley face on the Fed.

But there is trouble, and Big Ben is cracking the whip in no uncertain terms. Using the proceeds from the MBS to buy Treasuries may only be the beginning. If the economy doesn’t pick up more than it has, the Fed could begin printing money in earnest again. Bernanke has made it clear that he will do whatever it takes to prevent deflation, and he will risk rising inflation even if it means riding close herd on the increasingly shaky majority that agrees with him.

For the complete Hilsenrath article, click here.

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