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A $6 trillion Fed balance sheet?

You've probably been hearing some things lately about the unprecedented rise in the Federal Reserve's balance sheet. Today's post will focus on two recent articles from Barron's covering this subject.

The first, by Jack Willoughby, explains that the Fed's recent lending spree has swollen its balance sheet in recent months, increasing the risk of future inflation in the process.

An excerpt from, "Has the Fed Mortgaged Its Future?":

"IF THE FEDERAL RESERVE BANK WERE A COMMERCIAL LENDER, it would be a candidate for receivership, based on its capital ratios. Bank examiners generally view any lender with a ratio below 2% to be dangerously undercapitalized. The Fed's current capital ratio, or capital as a percentage of assets, is 1.9%.

The Fed has provided so many loans and emergency credits -- to banks, brokers, money funds and foreign countries -- that its balance sheet, viewed one way, is as leveraged as any hedge fund's: Its consolidated assets amount to 53 times capital. Only 11 months ago, its leverage on this basis was a more modest 25 times, and its capital ratio 4%. A caveat: Many of the loans are self-liquidating facilities that will disappear in a few months if the financial crisis eases.

Although the Fed's role as a central bank is much different from the role of a private-sector operation, the drastic changes in the size and shape of its balance sheet worry even some long-time Fed officials. Its consolidated assets have swelled to $2.2 trillion from $915 billion in about 11 months, and contain at least a half-dozen items that weren't there before. Some, like a loan to backstop the purchase of a brokerage, Bear Stearns, are unprecedented. (See table for highlights.)

Critics say this action could hinder the Fed in achieving its No. 1 priority: keeping inflation in check. To try to get in front of the crisis, many decisions have had to be made on the fly.

"If the Fed had been [a savings-and-loan] ballooning its balance sheet so fast, the supervisors would have been all over it," says Ed Kane, a Boston College finance professor." "

Willoughby's article goes on to point out that despite the recent alphabet soup of Federal Reserve and Treasury enacted lending facilities/bailout programs, banks remain reluctant to lend. Why? Simply, "because no one's sure who's solvent".

Meanwhile, an article from Jonathan Laing in the latest issue of Barron's argues that the Fed is not doing enough, and should take "far bolder steps to stem this crisis". In fact, Laing feels the Fed's balance sheet should increase to "$6 trillion or more" in order to stop asset prices from tanking.

Excerpts from, "Shopping Season for Uncle Sam":

"THE GOVERNMENT'S LATEST INTERVENTION IN financial markets -- the $800 billion plan unveiled last week to boost lending to consumers and trim mortgage rates -- hasn't been much more successful than its earlier efforts.

While rates on home mortgages dipped by a half-percentage point, that was about it. The Dow rose only fitfully after the initiative was announced Tuesday, following a torrid 12% rally in the previous two trading sessions. And most credit trading, including that done in the all-important corporate-bond market, remains in a deep freeze. The spread of corporate-debt yields over those of Treasuries barely budged from near-Great Depression highs. Businesses with non-investment-grade debt are paying a stunning 20% or more to borrow.

Little wonder, then, that a growing number of credit-market participants and Fed watchers maintain that far bolder steps are needed to stem the damage to both Wall Street and Main Street.

THE FED WILL HAVE TO LEAD the charge, they say. They recommend that the central bank purchase or guarantee massive amounts of all sorts of credit instruments to unclog the markets and push interest rates down from their punishing levels.

While the Fed has more than doubled its balance sheet in less than four months, with assets now totaling $2.2 trillion, much more may be needed. The central bank's holdings may have to swell to $6 trillion or more to stem the destruction of capital. The Fed, under the emergency powers in its charter, wouldn't even have to ask permission from Congress to grow like that."

In other words (as Laing's article seems to argue), the Fed should continue to intervene in the market by speeding up its printing press and buying all manner of paper assets in an attempt to "alter negative market psychology". I'm told the kids call this "quantitative easing".

But aren't these actions likely to produce highly inflationary results? That's what we're trying to figure out. And that's why I've linked to Axel Merk's latest article on this subject called, "Monetizing the Debt".

You've read the articles posted here, and probably a lot more on this issue besides. What do you feel the likely outcome will be?

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