It’s been about 2 months since the Federal Reserve has released its minutes from the March 16 FOMC meeting. Most of the content within the minutes was pretty mundane however, there was one section dealing with various “exit strategies” typically referred to as “reserve draining tools” that really made me sit up and take notice:

The staff also briefed the Committee on potential approaches for managing the Treasury securities held by the Federal Reserve. To date, the Desk had been reinvesting all maturing Treasury securities by exchanging those holdings for newly issued Treasury securities, but an alternative strategy would be to allow some or all of those Treasury securities to mature without reinvestment [emphasis mine]. Redeeming all of its maturing Treasury holdings would significantly reduce the size of the Federal Reserve’s balance sheet over coming years and hence could be helpful in limiting the need to use other reserve draining tools such as reverse repurchase agreements and term deposits. Redemptions would also lower the interest rate sensitivity of the Federal Reserve’s portfolio over time. Nevertheless, the initiation of a redemption strategy might generate upward pressure on market rates, especially if that measure led investors to move up their expected timing of policy firming. Participants agreed that the Committee would give further consideration to these matters and that in the interim the Desk should continue its current practice of reinvesting all maturing Treasury securities.

The staff appears to recognize that they cannot rely on the ability to sell the mortgage backed securities nor rely on the repo market to drain cash from the system. Duh. So, the Treasury portfolio is again on the chopping block. Again?

This is akin to the December 2007 through May 2008 period when the Fed rolled off its short dated Treasuries in order to get the cash to fund the various liquidity facilities as a cover for masking the insolvency of the banking system.

At the time, they had no other sizable category of assets on their balance sheet to liquidate. Selling the Treasuries was the only way to get the necessary cash. When the crisis hit full bore in September 2008, the Fed was desperate and asked the US Treasury to sell $500 billion in extra debt and put the resulting cash on deposit at the Fed to use at the Fed’s discretion. This was the Supplementary Financing Program (SPF).

As the markets began to rebound in March of 2009 with the announcement of the Fed’s purchase of $300 billion in Treasuries, many market participants took this to mean that the Fed was printing. In fact, Bernanke tried to convey exactly that during his 60 Minutes interview that month. I have always taken a contrary view that the Fed was merely replenishing the Treasuries that it had previously sold to deal with the credit crisis. To wit, the Fed H.4.1 from 11/29/2007 lists $779 billion in Treasury securities and the most recent H.4.1, 06/3/2010 lists $777 billion.

Today, the Fed has $200 billion in SPF funds at the ready for any immediate liquidity needs. And now the Fed staff is discussing the possibility of selling the Treasury portfolio again. When I first read those minutes above, I wondered if perhaps the staff recognized that we are not suffering from an ongoing liquidity crisis but rather a solvency crisis. That perhaps they now know that economic decline is inevitable and job No. 1 is to “manage the decline”.

The recent experience of the Europeans and their attempts to paper over insolvency with more debt rebuffed by the markets, have caused policy makers in Europe to do an about face and promote policies to manage their inevitable economic declines through austerity. Although the Obama administration seems loathe to reign in deficits here, the political climate in Congress is shifting. US austerity is in the offing. And the Fed looks to have only about $1 trillion in potential cash to manage a decline of potentially $25 trillion (everything from the internet and housing bubbles) in credit deflation. “Mr. Scylla, meet my friend, Mr. Charybdis.”