Minoans, for the sake of argument, who do you think is going to buy agency debt at anywhere near the price the Fed has been buying at the past several months early next year? And if so, what's that going to do to mortgage rates?

If the Fed does completely exit, I think you are going to see mortgage rates spike *significantly* ... Who wants to hold agency debt with no *actual* backing of the US Federal Government at 4 to 5% yields? I wouldn't. Given the shape of Fannie and Freddie's finances, they're basically junk bonds.

In addition, my current thinking is that the Fed should be able to exit its purchase program in March without much 'trouble'. That's not to say that deflationary pressures won't pick up as a consequence, it's just that I view the excess reserves as a response to the Interbank lending market dysfunction. There currently seem to be adequate reserves in the system to perform the clearing function.

Harmoniker, the problem as I understand it is that we don't know the quantity or price of the MBS purchased. They could have demanded a significant haircut from par. But your point still seems valid. To the extent that they cannot sell or the redemption does not yield above their purchase price (whatever that was), they are at risk. A de-facto reserves targeting. I don't like the term 'monetization' either since the reserves themselves yield something more than currency.

For these and other reasons, I think the Fed is going to have a very hard time unwinding its MBS / agency debt purchases in Q1 of 2010, even though that is their current stated policy. And I don't think they're going to be able to get this crap off their balance sheet any time soon.

Mr. Fed, I, like you, agree that the MBS / agency debt purchase program the Fed is undertaking is not monetization per se. But, would you not agree that by providing the sole bid into a currently illiquid market, they have effectively become the only buyer for these items? How do they now exit, without selling these items at a steep discount from their purchase, other than force offloading them to the Treasury/taxpayer at original price? Furthermore, if they do sell into the market, would that not create much higher yields for agency debt, sending mortgage rates significantly higher? And if they sell these items at a discount/loss, you could make an argument that the difference between their buying price and the new market price is a monetization of sorts, as that cash has trickled into the economy, at least until they undertake further sales of assets to mop up said excess cash.

The great Aline van Duyn is doing a series of daily short videos over at ft dot com that is quite good. She's quite succinct and very knowledgeable; the best writer I know of on derivatives in the financial press. Just go their site, access the VIDEOS section towards the bottom of the web page and click on the most recent Short View videos to get started.

Capacity underutilization was also a cornerstone of the KC Fed's revolutionizing of monetary policy in 1982 when they correctly forecasted (to the shock and horror of Milton Friedman and the St. Louis Fed) that the astonishing monetary growth during that period would not cause inflation.

They were correct. It did not.

Re: 1936, I have not studied that episode closely. I think there may be more factors at play here other than just Fed policy. The world was interconnected in many ways in 1936. Europeans and the US invested in each other's economies. And in 1936 we had the outbreak of the Spanish Civil War and Hitler's occupation of the Rhine, as well Landon's candidacy against Roosevelt challenging his "easy money" government spending policies.

All of these factors easily could have decreased inflationary expectations and promoted a generalized slowdown.

In terms of the role of excess reserves, it is somewhat frustrating that banks are still afraid to even lend to each other to some extent, much less the broader economy. But that issue has improved noticeably this year.

Hi Minoans. Thanks for your continued outstanding contributions!

I am not at all persuaded that the Fed policy viz a viz MBS purchases can accurately be characterized as QE or reserve targeting. Bernanke has explicitly stated this is not the case. Rather they are taking the role of an MMLR (market maker of last resort) to keep bid and ask spreads relatively narrow as this critical MBS market discovers its new price level.

Apropos my earlier comment on reserves, I am troubled by Bullard's remarks earlier on the need to extend (or possibly buy more) MBS purchases past the March deadline. It appears to me that the existing reserves targeting policy has amounted to little more than ensuring the check clearing capacity of the existing banking system. To be sure, an argument can be made that it has had an impact on mortgage rates, however, the banks are not financing many new mortgages, the gov't is. Why would Bullard advocate for more reserves?