While central banks stress-test private banks, James Hamilton stress-tests the Fed.

if interest rates should rise more quickly than the Blue Chip consensus, the Fed’s losses would be larger than anticipated under our baseline assumptions. In our paper we evaluate a number of alternative possibilities. To highlight the most dramatic of these, if the Fed continues expanding its balance sheet during 2014 rather than hold it constant as assumed in our baseline scenario, and if interest rates are 200 basis points higher starting in 2016 than assumed in our baseline, we calculate that the Fed’s deferred asset account could reach as high as $370 B.

I think that it all depends on the fiscal environment. The left-wing pundit view of the world is a double “Don’t worry.”

1. Don’t worry about a default on the debt, because it is denominated in our own currency.
2. Don’t worry about inflation, because it is low now and will be low in the future.

Yes, I can construct a scenario in which both of these “Don’t worries” pan out. However, I also can construct a stress test in which they become contradictory. Suppose that in 2015, inflation has reached 5 percent, the interest rate on short-term Treasury debt is 7 percent, and the rate on long-term debt is 9 percent. Because of the high level of debt, the government is choking on its interest expense. Under those circumstances, I have a hard time picturing the Fed being allowed to curtail its purchases of Treasury securities, much less sell them off. In other words, to resolve worry #1, the Fed has to keep expanding the money supply, which compounds worry #2.

The pundits who tell us not to worry about short-term fiscal policy think that those of us who are worried about it are nutters. I hope they are right. If the progressives are sober, and I am a nutter, then the country is in good shape. If it’s the other way around, then heaven help us.

Have a nice day.