180 THE BiG DROP
- The Fed is now insolvent. By buying highly volatile
long-term Treasury notes instead of safe short-term
treasury bills, the Fed has wiped out its capital on
a mark-to-market basis. Of course, the Fed carries
these notes on its balance sheet “at cost” and does
not mark to market, but if they did they would be
broke. This fact will be more difficult to hide as in-
terest rates are allowed to rise. The insolvency of the
Fed will become a major political issue in the years
ahead and may necessitate a financial bailout of the
Fed by taxpayers. Yellen is a leading advocate of the
policies that have resulted in the Fed’s insolvency. - Market participants and policymakers rely on mar-
ket prices to make decisions about economic policy.
What happens when the price signals upon which
policymakers rely are themselves distorted by prior
policy manipulation? First you distort the price sig-
nal by market manipulation and then you rely on
the “price” to guide your policy going forward. This
is the blind leading the blind.
The Fed is trying to tip the psychology of the consumer
toward spending through its communication policy and low
rates. This is extremely difficult to do in the short run. But
once you change the psychology, it is extremely difficult to
change it back again.
If the Fed succeeds in raising inflationary expectations,
those expectations may quickly get out of control as they did
in the 1970’s. This means that instead of inflation leveling off
at 3%, inflation may quickly jump to 7% or higher. The Fed
believes they can dial-down the thermostat if this happens, but
they will discover that the psychology is not easy to reverse
and inflation will run out of control.
The solution is for Congress to repeal the dual mandate and
return the Fed to its original purpose as lender of last resort and
short-term liquidity provider. Central planning failed for Stalin
and Mao Zedong and it will fail for Janet Yellen too.