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Bernanke spends a billion $ here a trillion $ there! What happens next?

Seeing Fed brilliance in action! 

Part 2 of 3, White Top View series:

The FED, Bernanke and tapering

Ben Bernanke and the U.S. Federal Reserve Bank will self-liquidate well over $1.3 trillion massive mortgage inventory by simply letting the bonds mature.

That great pile grows larger at the rate rate of $85 billion more each month! We began discussing this in Part 1, 5 to 10 years of Fed taper effect coming. The current talk of tapering was started by Fed Chairman Ben Bernanke. That conversation signals the pending end to this unprecedented stimulus program.

As noted in Part 1, this program will directly affect the market for at least another 5 years. Then, once this gusher of money gets turned off, what will happen? Will that huge pile of mortgages overhang the market?

Move along, nothing to see here…

In a word, no. Not much will actually happen. The Fed will sit on the inventory. Remember their purpose, to get the economy going. The current program works towards that goal through massive stimulation of the mortgage market.

Once that market establishes a new normal, the program will end. It will be a gradual or tapered reduction. That will happen over at least several months and likely extend for more than a year. However they get there, it will eventually come to an end.

When that happens, they will stand aside. No further stimulus will be needed. The Fed will be out of the market. With success they can declare victory but still have to deal with that accumulated inventory.

Only then will a true normal market exist.

Liquidation risk

But the Fed will not upset the new supply and demand balance by liquidating inventory. Fed selling into the market would be disastrous.

Doing so would have the same effect as an excessive increase in private capital becoming available. To work, a normal market uses price to adjust the balance between supply and demand. Any significant increase in either supply or demand produces price responses to balance the forces.

Keeping that basic balance requires the Fed to let their inventory self-liquidate. That will help maintain an orderly market. Therefore the Fed will simply let their bond inventory mature. Brilliant!

Refinancing mortgages

Essentially the inventory consists of an unimaginably large but very real pile of 5 year bonds. As each matures, normal refinancing occurs. The old bond gets redeemed or paid off. The new or replacement bond sold into a normal market to serves as the replacement.

The Fed simply stands aside from the new transaction. Like a rich wizard quietly getting the wanted outcome.

This will happen millions of times as your neighbors and millions of others go through routine mortgage refinancing. As a result the Fed quietly reduces inventory without upsetting the market and we all happily carry on to prosperity.

Well that is the theory. Being us, we will find some way to make this more exciting in the years ahead. For now we can be content that the Fed has done an incredible, innovative and effective job. For now we are happy with the good news; the market continues to mend.

Do you think Fed tapering will happen before mid 2014? Let’s talk about it.

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White Top Investor
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Image courtesy of U.S. Federal Reserve Bank.

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