Federal Reserve Balance Sheet Risks

January 5, 2012

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Bernanke Capital’s purchase of garbage assets exposes the Central Bank to both “interest rate risk” and “credit risk” since they purchased toxic assets at above market rates, and despite reporting “profits” to Congress from the nickels they’ve picked up – interest rate payments – the steam roller is the capital losses they are sitting on.

Bernanke Capital is not subject to the same rules of law as companies and other hedge funds, so they do not mark to market their losses. Since Bernanke Capital is now implementing similar positions as MF Global, via back door swap lines.

The question: what are the implications? We can expect losses to the taxpayer via an inflation tax.

The Fed is not going to sell their assets until they have a profit, which will be long after the inflation genie is out of the bottle. The balance sheet incentivizes the Fed to tolerate higher inflation than otherwise would be tolerated. An estimate of the value of the portfolio relative to the purchases could allow one to time a tightening cycle.

The exit will be long after the inflation genie is out of the bottle. While they would like to inflate the assets prices on their balance sheet, the Fed can create inflation, but cannot by determine where that inflation will go.

The QE moniker is toxic, so one possibility is a rebranding, "GDP Targeting" or “Inflation Targeting.” This equates to “unlimited money printing” at the Fed’s discretion.

The lower probability "Unemployment Targeting" is much more frightening. The Fed equates high inflation with lower unemployment, the “Philips Curve.” This is bullshit. After all, how does the Federal Reserve, by flooding the world with cheap money, retrain millions of housing related professionals into software engineers? You could get high inflation and high unemployment with this path.

The tail event is if Obama loses in 2012, we could see a radically different Fed, which would send stocks down to their real value.

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