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Price rebound will eventually win the race against

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price rebound will eventually win the race against further losses on GSE mortgages, limiting future holes to be plugged. But the outcome of that race looks increasingly uncertain. In summary, it is unclear why the Fed is the right choice as a long-term storage facility for GSE securities. This is really the task of an asset-management company. Even the Fed’s holdings of securities from Bear Stearns and AIG are being “run” by an asset management firm for a fee. All of this can be transparently done through an RTC-style “bad bank” that is owned and funded by the Treasury. For now, however, things remain rather murky. The mingling of the Fed in the government’s quasi-fiscal (“quasi” only because it involves off-balance sheet debt and risks) has raised some difficult questions for the Fed’s other roles, to which we turn next. 6.3. To raise or not to raise A principal conflict that has arisen with the Fed’s ownership of GSE securities is the following: Will the Fed’s incentives be well-aligned with the economy’s long-term growth and inflation prospects when it comes to raising interest rates? There are at least two issues worth considering:
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83 One, even though GSE securities and debt are effectively guaranteed by the U.S. government, carrying them on the Fed’s balance sheet entails market risk due to changes in interest rates and prepayments. Suppose from the standpoint of price stability that it is desirable for the Fed to raise interest rates. Doing so would hurt the value of securities on its balance sheet. What would the Fed do? Would it err on the side of letting inflation build up? One could argue that someone has to bear the interest rate risk of these mortgages when rates rise, and why can’t the Fed just take the losses? The issue, however, gets tricky when one considers the likely public and political perception of significant losses on the Fed balance sheet, especially given the criticism that its extravagant role in the crisis has already invited. The current decision-makers at the Fed might feel somewhat caught up in their past decisions – much as corporate boards do in biting the bullet and firing an incompetent CEO that they themselves hired. Second, the reason why the Fed has felt comfortable buying GSE securities and continuing with purchases of Treasuries is that banks mostly leave the swapped reserves (“money”) in accounts that they maintain with the Fed. Since October 2008 (expedited from the originally planned 2011 date), the Fed has been paying interest on reserves that banks maintain with it. Paying interest on reserves has ensured that even though the Fed created and used the reserves to purchase securities, they are not floating around in the economy multiplying the quantity of financial transactions and running the risk of triggering inflation. When the Fed raises interest rates, it will have to pay more on these reserves. If the Fed has not been able to
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