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Unstimulating America - How do you Undo a Trillion Dollars?

That question has been on the minds of leaders and financial thinkers worldwide, since the financial crisis broke last fall.

In response to falling asset prices, governments around the globe created trillions of dollars in stimulus spending and rescue funding. In the U.S. alone, the monetary base grew by a trillion dollars in a matter of months.

At the time, it was believed that the crisis had to be stemmed at all costs. Politicians recognized that massive money creation could lead to inflationary problems down the road. But they took a "deal with that bridge when we come to it" approach.

Today, some analysts see that bridge before us. Inflation concerns are once again rearing up. Gold jumped above $1,200 per ounce. Yields on inflation protected U.S. government bonds recently fell to their lowest since March 2008, signaling that investors were buying in to protect against rising asset prices (although yields have been rising again in December).

If we are really seeing inflation, it's time to start considering how to unwind all the stimulus money that's been pumped into the financial system. Can we really vanish a trillion dollars?

A couple of recent developments are encouraging on this front. The U.S. government has indeed been successful at draining liquidity from the system in a number of areas.
The most high-profile is the Troubled Asset Relief Program (TARP). Over the last few weeks, a number of banks have repaid the billions they received from the government under TARP. Just today, Wells Fargo announced it has returned $25 billion in TARP money.

Overall, TARP has proven to be a successful example of interventionist banking. It now appears that most of the $150 billion given out under TARP will be returned to the government less than a year later. Washington may even turn a profit on the program.

Another place where government money has gone and come, is the Term Auction Credit facility. Under this program, the Federal Reserve lent directly to banks across America to keep them solvent during the worst of the crisis.

Back in March, banks borrowed nearly $500 billion under this program. It was one of the major reasons the monetary base ballooned so fast.

But banks have steadily been returning this money. To the point where there is now only $100 billion of credit outstanding. $400 billion has come home to roost.

Perhaps the least-known source of new money over the past year was central bank liquidity swaps. As the crisis broke last fall, demand soared for dollars as a safe-haven investment. Businesses that needed dollars to function were having a hard time procuring the currency.

In response, the Federal Reserve lent dollars directly to central banks in Britain, Japan and several other of the world's largest economies. These swaps were the single biggest source of money creation globally. At the peak, the Fed pumped out $570 billion in loans to central banks.

At the time, there were concerns that this slug of cash would wreak inflationary havoc. But the results have been completely benign. As of December 16, $557 billion of these swaps had been repaid. Leaving just $14 billion outstanding.

All of these programs suggest it is possible for the Pandora's box of money creation to be closed again after opening.

The big question now: can the same unwinding be accomplished for programs like the Federal Reserve's operations in the mortgage market? Fed purchases of mortgage-backed securities (MBS) are by far the largest contributor today to increased money supply. The Fed has bought $900 billion in MBS over the past year, and shows no signs of slowing down. Meaning that $900 billion in new cash has gone out the door to pay for these purchases.

Notionally, this money could be drained out of the system. If prices for mortgage securities improve, the Fed could sell its holdings. This would bring $900 billion (and possibly more) back into Fed coffers, drawing it "off the street".

Of course, this requires a recovery in the mortgage market. Far from a certainty. This will be the next big test for the U.S. government's great experiment in monetary policy.

Here's to staying liquid,

By. Dave Forest of Notela Resources




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