I’m going to begin this Hamill Economic Update by laying out the overall premise that I am seeking to teach.  Hopefully, this will help the reader to understand each concept that I cover in this next series of articles.

Facts

1) The Fed has purchased over $1.1 trillion dollars of mortgage-backed securities, with another $157 billion of Fannie Mae and Freddie Mac “agency” debt thrown on top.

2) These MBS securities and agency debt were purchased at full price with new dollars that the Fed created, but those dollars have to sit in the Excess Reserve accounts of the various banks instead of circulating into the economy – otherwise we would see major inflation occur due to the vast increase in the nation’s money supply.  Banks are earning interest from the Fed on these holdings.

3) The MBS securities and agency debt are only worth about 20 cents on the dollar, but the Fed paid the banks 100 cents on the dollar.  In other words, 80 cents of every dollar the Fed holds of these securities is absolutely worthless.

Dilemmas

1) How is the Fed ever going to sell off the MBS and agency securities that it holds and receive full price?  If they don’t, then those securities will continue to pollute their balance sheet for many decades.  Who would pay full price for junk?

2) How will the banks ever be able to spend their Excess Reserve holdings into the economy without creating massive inflation?  How can they keep all of that money, eventually be able to spend it, and still prevent our nation’s money supply from increasing?

The Federal Reserve announced two weeks ago that it was going to “reinvest” some of the income from its mortgage-backed securities (MBS) back into US Treasury securities.  Fed takes small step to bolster recovery.

Many professional financial analysts, along with a myriad of economic prognosticators, took this news as being inflationary – boosting the money supply to higher levels.  It makes it look like the Fed is putting forth an effort to help us exit this economic mess.  Please allow me to show you how this analysis is completely wrong.

Let’s begin by discussing how the Fed adds money to the nation’s money supply.  It does so by purchasing US Treasury securities on the open market with newly created Federal Reserve Notes (FRN’s), or what we call dollar bills.  The Fed gets the US Treasury securities as an asset to its balance sheet, while the FRN’s get circulated into the overall economy – thus increasing the money supply.  This is inflationary.

The Fed decreases the money supply in the exact opposite way.  It sells US Treasury securities on the open market and receives FRN’s back in return.  It then proceeds to destroy these FRN’s – thus decreasing the money supply.

This is where people are getting confused.  They think that the Fed buying US Treasury securities is going to be inflationary, because that’s what they’ve always been told.  However, this case is a little bit different.

Let me give an example.  Your friend has two $5 bills.  You have nothing.  What is the total money supply between you and your friend?  The answer is $10.

Your friend loans you their $10 at no interest, with you verbally promising to pay them back at some point.  What is the value of the money supply now?  Is it $10?  No, it’s $20.  You have $10 that your friend lent to you.  Your friend has a $10 loan that is secured with your verbal promise to pay them back.

Now you decide to return a $5 bill back to your friend as partial principal repayment.  What is the value of the money supply?  It is $15.  You have $5 remaining from the original loan.  Your friend has a $5 loan balance secured by your verbal commitment to repay, plus a $5 dollar bill.

Do you see how the money supply was reduced from $20 to $15 by you repaying principal on your loan?  All principal payments on all “credit outstanding” in our nation reduce the overall money supply by the amount of the principal paid.

Now let’s apply this knowledge to the Fed.  The Federal Reserve has been buying lots of mortgage-backed securities from banks.  I estimate that a full 80% of those securities are worthless, but there are still 20% of the loans in good standing where people are making their mortgage payments.

What happens when somebody makes a mortgage payment where the principal amount of the payment ends up going to the Fed?  Answer: the overall money supply in the nation will decrease by the amount of that principal.

This is what those espousing inflation fail to recognize.  The principal payment coming in the back door at the Fed will be sent out the front door to purchase US Treasury securities.  Yes, the purchase of the securities will put that principal payment back into circulation, but it will not cause an increase in the money supply.  There is no new money being created.  Instead, the decrease caused by the loan principal payment will cancel out the increase caused by the US Treasury security purchases.  There will be a net zero effect.

You should be asking yourselves why the Fed would even bother doing this if it doesn’t increase or decrease the money supply.  I will answer more of that question next time.

Your comments are appreciated…

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Thanks,

Chris Prang