For the Fed, There's No Easy Exit

By GEORGE MELLOAN, WSJ

The crash of Zero Mostel's quasi-Ponzi scheme in 1968's "The Producers" left his partner Gene Wilder muttering, "No way out. No way out." Federal Reserve Chairman Ben Bernanke is in a somewhat similar position. Keynesian monetary "stimulus" has failed to revive the housing market, the federal deficit remains at a three-year flood tide, and the recovery is moving at ant-like speed. Americans enjoyed "The Producers." They're not enjoying this.

Presidential candidate Ron Paul's call to scuttle the Fed and return to a gold standard is getting surprising resonance with Republicans, judging from his strong showing in the Maine and Minnesota caucuses. Despite a rising chorus of complaints from seniors, pension funds and frugal savers about scanty returns on investments, the Fed has committed itself to nearly three more years of zero interest rates.

Mr. Bernanke defends that commitment on grounds that low interest rates will continue to make mortgages cheap and help the housing industry recover. But the housing market can't clear until the inventory of distressed housing is worked off. And that process is being inhibited by federal policies to forestall mortgage foreclosures, including a $25 billion shakedown of five big banks as a penalty for alleged foreclosure abuses.

There is no end in sight to the pressure on the Fed's balance sheet. The Fed has acquired over a half trillion dollars (net) of Treasury securities over the last 12 months. Its holdings are up to $1.665 trillion and it is financing some 40% of the deficit—which is now running at a $1.3 trillion annual rate and heading for another collision with the debt ceiling, possibly late this year.

The Fed still holds $836 billion of suspect mortgage-backed securities on its books, bought mainly to bail out Fannie Mae, Freddie Mac and AIG. The Fed lists them at par (the remaining principal value of the underlying mortgages). But sales from the AIG tranche over the last year have shown their market worth to be somewhere around 50 cents on the dollar.

The Fed nonetheless booked a surplus of $79.9 billion for 2011, mainly from the interest on its government securities. But by law that goes back to the Treasury. So in effect the Fed earns expenses and little else on its holdings, meanwhile taking a big risk. It is subject to a huge capital loss on its portfolio if interest rates rise and the market price of Treasurys goes down. That gives it one more incentive to hold interest rates as low as possible, despite the rising public clamor for higher returns on investment.

But as the U.S. economy continues its feeble recovery, banks are getting greater demand for more-lucrative industrial and commercial loans, which pay a much higher return than the quarter of a percent the Fed pays banks on its borrowings from the $1.5 trillion in reserves they hold in excess of their legal requirements. It uses those borrowings to buy government debt. The Fed could use its considerable muscle with the banks to hold on to those reserves, but denying lending to the private sector hardly furthers its professed goal of stimulating the economy.

Nonetheless, the Fed is indeed using its muscle to conscript banks into helping it shoulder the federal deficit. The "Volcker Rule" drafted by the Fed and other agencies that regulate banks is a product of the Dodd-Frank Act intended to prevent depository institutions from trading for their own account. But guess what? There's no restriction on trading in Treasurys. Thus the draft regulation joins Basel II regulations, which gives Treasurys a zero-risk rating in the risk-based capital requirements for banks, in tilting bank lending away from the private sector and toward supporting the federal government.

Former FDIC director Sheila Bair has called the Fed's Volcker Rule draft a 300-page "Rube Goldberg contraption," and even Paul Volcker has criticized it. A recent Journal article reported that foreign central bankers are furious that the U.S. Treasury escapes a ban that will apply to trading in their securities.

Bankers are up in arms as well, none of which helps Mr. Bernanke's relationship with the constituency he once represented before the Fed decided to become the handmaiden of the White House and Congress. But he has bigger troubles than that. The Treasury will keep rolling out tons of low-interest debt and someone has to buy it. Mr. Bernanke has been lucky that Japan and China continue to buy Treasurys and that European debt has been in bad odor, thus sending investors to U.S. bonds as a haven of last resort.

But how long can that last? Chinese and Japanese demand is slipping and there are at least some signs of light in Europe. All of the available signals point to the likelihood that the Fed will have to turn to more vigorous creation of new money (inflation) at some point—or face the possibility of rising market rates on government securities that sharply raise the Treasury's borrowing costs and devalue the Fed's enormous balance sheet.

No way out. No way out.

Mr. Melloan, a former columnist and deputy editor of the Journal editorial page, is the author of "The Great Money Binge: Spending Our Way to Socialism" (Simon & Schuster, 2009).