Bruce Krasting

How The Federal Reserve Is Monetizing Debt

Nice article. Excellent graphics. A few comments:

The deal to buy Agency MBS was not a slight of hand as you suggest. The Asian Central Banks put a gun to Bernanke last year and said, "Buy this stuff back at par or we will never buy a dime of T notes again."

So Paulson/Bernanke said, "Okay, but you have to agree that for every dollar of Agency junk we take back you have to take an equal (or greater) amount of Treasury paper.

So that was the deal.

The purchases of Agency Paper are being funded by the excess reserves that the Fed has created. This is why the Fed started paying interest on reserves. So that it would attract sufficient money to allow it to buy up all of the junk. (This is the QE process)

On the dollar. You make a pretty good case for a flow of funds that argues for a lower dollar. That may happen, but it is not a sure thing. The dollar has had an uphill battle on the fundamentals for decades. We have always run a current account deficit that had to be financed by 'willing' foreign central banks. Because of the weak economy our imports are down and the traded deficit has actually improved a bit.

There are two factors for the dollar. Flow of funds and sentiment. The flow of funds is an important element in the equation but in the short term is overshadowed by sentiment which is not negative today. This is a reflection of the Store of Wealth factor for any reserve currency. Which currency is the best Store of Wealth? That is a hard question to answer. They all stink. The Euro has a huge set of problems. Possibly more significant than we face. The Yen looks like a standout in that but who cares? It is a very expensive currency today and on an economic Store of Wealth Basis is probably worth 110 vs 95.

So the % looks stable because there is no legit alternative. Keep in mind that to be a reserve currency you must have lots of debt for those reserves to be invested in. So while the third tier currencies (A$,C$,Sterling and CHF) may look attractive it is unlikely that they will get much in the way of reserve diversification.

We are going to get a run on the dollar at some point as a result of all of what has been done. But I would not bet on it happening anytime soon. Things have to get much worse in the USA for that to happen. It also has to evolve that some of the alternatives to the dollar truly start to look better.