Landlord of last resort ponders eventual open house

If Federal Reserve officials think U.S. homeowners are having a tough time selling into a depressed market, just wait until they try to offload the mother of all jumbo mortgages: a $366 billion portfolio of real estate bonds that continues to grow.

In this light, an eventual exit strategy from the Federal Reserve's multi-trillion dollar emergency measures might be viewed as the central banking equivalent of flipping houses, but on an epic scale.

It is not an enviable task. The U.S. central bank must weigh the necessity of removing reserves from the economy, because of potential inflation, against the reality that selling mortgage-backed securities could further dent that battered market, possibly pushing up mortgage rates.

A large chunk of the Fed's rescue efforts is a commitment to purchase as much as $1.25 trillion of mortgage securities issued by mortgage giants Fannie Mae and Freddie Mac.

Outstanding Fed credit, commonly referred to as the central bank's balance sheet, was historically composed mostly of highly-liquid U.S. Treasury bonds. Before the crisis started in the summer of 2007, 92 percent of its holdings of about $855 billion were made up of government debt, according to official central bank data.

As of May 7, 2009, the Fed's overall balance sheet has expanded to over $2 trillion, of which only about a quarter is Treasuries, with mortgage debt representing a growing slice of the Fed's asset base, according to the Fed's weekly H.4.1 report. (here)

It's going to be a massive undertaking, especially given the size that we are likely to see before all is said and done, said Kim Rupert, managing director of global fixed income analysis at Action Economics LLC.

Ben Bernanke, the Fed's current chairman, and his number two, Donald Kohn, have been quick to state they have plenty of ways of removing all the liquidity that has been injected into the financial system when the time is right.

We have a number of tools we can use, Kohn said in a recent speech. Among other capabilities, Kohn touted the newly acquired ability to pay interest on reserves held with the Fedwhich would give the central bank the ability to attract more deposits and restrain bank lending if inflation crept higher.

This could happen, analysts note, even without a substantial recovery in economic growth through a sharp selloff in the U.S. dollar, rising commodity costs, or both. Such fears are beginning to be reflected in interest rate futures markets, which are now pricing in a Fed interest rate increase, up from the current zero to 0.25 percent range, by year-end.

The threat of inflation is one that we need to be attentive to, in part because of the enormous borrowing on the part of the U.S. Treasury, said David Resler, chief economist at Nomura Securities.

Resler is in good company. Such concerns have been raised by prominent policy veterans like Paul Volcker, the former Fed Chairman who now advises President Barack Obama, and former U.S. Treasury Undersecretary John Taylor.

In a recent analysis, Taylor concluded that there is a systemic risk of inflation as a result of the excess reserves. Coming from the father of the so-called Taylor rule, widely used in central banking, which determines the ideal interest rate for a given set of economic conditions, his conclusions were unsettling.

My calculation implies that we may not have as much time before the Fed has to remove excess reserves and raise the rate, he said at an Atlanta Fed conference this week.

RESERVE (MIS)MANAGEMENT?

Attuned to such discontent, Bernanke has led a charge in the central bank's defense. Central to Bernanke's case is the notion that the Fed's programs are self-liquidating, meaning that an improvement in financial markets will automatically reduce the need for them.

This may indeed be true in certain instances. The Term Securities Lending Facility, one of the early efforts that sought to ease a squeeze on the Treasury market that came from a crisis-driven demand for safe-haven debt, has recently run out of demand as market conditions appeared to stabilize.

The same would likely happen with the international currency swaps aimed at meeting foreign demand for U.S. dollars.

However, full withdrawal from other credit creating programs, particularly the Fed's acquisition of mortgage bondswill not be simple.

Part of the problem hinges on Fed's ability to return all the mortgage debt it has taken on, at the risk of derailing a housing market that is expected to remain fragile for years.

Another concern is that, because inflation is generally a lagging indicator, it will not give policy-makers enough lead time to remove the stimulus.