However much it infuriates people like Paul Krugman to hear analysts warn about inflation while the economy is still sputtering along joblessly, there is good reason to worry about the ability of the Federal Reserve to prevent the massive build up of the monetary base from resulting in out of control inflation.



One of the sources of the growth of the monetary base has been the $1 trillion of purchases of mortgage backed securities by the Fed. Much of that hasn’t yet made its way into the broader economy, and instead sits on bank balance sheets. Actually, much of it is on deposit with the Fed itself, where banks can earn risk-free interest instead of lending it to home buyers at risk of losing their jobs or businesses still suffering from diminished consumer demand.



When the economy begins to recover, the Fed will need to reduce the monetary base to prevent all those dollars from flooding the market and triggering hyper-inflation. For some sources of monetary expansion this is relatively straight forward—the Fed can simply shut down various monetary easing facilities that operate like loans to banks. Banks will have to hand dollars over in exchange for the collateral they posted to participate in the lending facilities.



But things are not as easy when it comes to the mortgage backed securities the Fed purchased this year. These purchases increased the monetary base, which means they will have an inflationary effect when bank lending loosens. In order for the Fed to start sucking back these funds, it will have to sell these into the market. Unlike the repo and lending programs, however, the Fed cannot simply order the banks to repurchase the mortgage backed securities. It will have to sell them at market prices.



The market’s knowledge that the Fed has become a seller rather than a buyer for mortgage backed securities will likely result in the pricing of these securities falling. In order to bring the yield of these securities up to a level acceptable to the market, they will have to be sold at a discount. This discounting means that the Fed will not be able to withdraw as much liquidity as it added, leaving some portion of that $1 trillion (plus its multiplier effect) in the economy to create inflation.



Think of it this way. If the Fed bought a mortgage backed security for $100 but can only sell it for $90, there’s a 10% inflationary discount occurring. Which is to say, the Fed’s MBS has inflation built right into it. There’s no way out.



Notice, also, that there are also losses for the Fed built into this. The Fed has said that it does not anticipate losses from the program because the securities are backed by Fannie Mae, Freddie Mac, and Ginnie Mae. If it held them to maturity, losses would be unlikely. However, the Fed may not have this luxury if it needs to withdraw money from the economy to fight inflation. So its very possible the Fed could lose money on its mortgage market investments.



Ironically, the Fed’s losses might be made worse if the Fed tries to fight inflation by paying higher interest rates on bank deposits at the Fed. This is a new and powerful tool that the Fed can use to soak up excess bank funds—basically, paying interest rates high enough that banks prefer to keep money with the Fed rather than lend it out to non-risk free borrowers. Right now the Fed gets away with paying very little interest, since demand for loans is low and lending risks are still perceived as high. But as opportunities in the economy grow, the Fed will have to increase the interest rates to prevent inflationary lending.



The higher rates from the Fed, of course, will cause political outrage. Essentially, bankers will be able to make handsome returns by not lending to businesses and consumers. It will be perceived—rightfully so—as a super-perverse subsidy.



And those higher rates will make it harder to sell the mortgage backed securities. The Fed will have to sell at even greater discounts, since bankers would rather just earn interest from the Fed unless the discount on the MBS—and therefore the yield—grows high enough. And, of course, each discount makes the inflation-fighting impact of the mortgage-backed-security sale less effective.



This promises to be a costly situation for the Fed—fighting inflation by paying high interest rates on deposits while selling mortgage backed securities at ever steeper losses. And there is no escaping the built-in inflation from the mortgage security purchase program.