There are many who argue the Fed has violated their charter by adding non-Treasury assets. The interpretation of statutes may have legal significance but it is irrelevant to markets that are being increasingly dominated by China, Japan, etc. The Fed has become substantially more risky, perhaps as much as some of the banks they have bailed out. Of course, they, in conjunction with the Treasury, have something called a printing press that individual banks do not.
Per this chart, the Fed had about $800 billion of safe assets in December 2007. Virtually all of this was Treasuries. Now, the Fed’s holdings of Treasuries has been reduced to about $400 million. Much of the rest, arguably, might be considered toxic waste. Thus they have gone from 100% safe assets to about 20%.
Another interesting observation from this chart is that the Fed actually reduced their holdings to close to zero until March of this year. At that point 100% of what they were carrying could have been considered junk or high risk. Since March the Fed has been building up its holdings of Treasuries using reductions in bank loans and the return of rescue funding as sources.
It is likely that the “safest” assets are the ones that have already been paid back to the Fed. If the Fed had any intentions of an exit strategy, the paydown of these assets would have been a natural way to implement it. On the other hand, it is entirely possible that it was necessary for the Fed to buy Treasuries in order to not have failed Treasury auctions. If so, that means that they likely will be buying many more Treasuries in the future, presumably not being able to fund them with paybacks as occurred within the last few months.
The assets on the Fed’s balance sheet are the best indication of liquidity or potential money in the financial system. In about 3 months these assets rose by well over 100%. Much of this is dry tinder being held as excess reserves by banks, probably in anticipation of greater losses to come. Any misplaced match however could ignite this tinder. Whether this happens soon or further down the road cannot be reasonably forecast. It is doubtful that the Fed’s balance sheet will decrease materially from here. It is more likely to double before this mess is over.
It is very difficult to envision a scenario that doesn’t end in very high inflation. The timing of that is less certain.