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Tuesday, July 21, 2009 1:34 PM

At Long Last - Fed Explains Exit Strategy

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After months of hemming and hawing Fed Chairman Ben Bernanke has finally detailed The Fed’s Exit Strategy in an Op-Ed in the Wall Street Journal.

The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the interest-rate target for overnight lending between banks (the federal-funds rate) nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. The Federal Open Market Committee, which is responsible for setting U.S. monetary policy, has devoted considerable time to issues relating to an exit strategy. We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.

The exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds enter the banking system and ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. And given the current economic conditions, banks have generally held their reserves as balances at the Fed.

But as the economy recovers, banks should find more opportunities to lend out their reserves. That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—unless we adopt countervailing policy measures. When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy.
Bernanke Explains Fed Tools

The tools Bernanke mention in the article are:

Paying interest on reserves. This was authorized by Congress in 2008. Supposedly this was going to put a floor on interest rates at 2%. Given the Fed Funds Rate is now 0%, that tool has a spectacular record of failure. Bernanke thinks that "Under more normal financial conditions" paying interest on reserves will work. If not, Bernanke mentioned four more options.

1) "The Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions."

A repurchase agreement (repo) is a temporary injection of cash with an expiration date. A reverse repo is the opposite, a short-term drain of cash, in other words a short-term tightening of credit.

2) "The Treasury could sell bills and deposit the proceeds with the Federal Reserve."

Buying bills (a coupon pass) is a longer-term injection of cash. Selling bills is the reverse, a longer-term drain of cash. Given that both repos and coupon passes can easily be reversed at will, the terms temporary and long-term are not necessarily meaningful. Indeed, the Fed has frequently gone into periods where expiring repos are replaced with another repo on the expiration date. Thus 1) and 2) are essentially the same thing.

3) "Third, using the authority Congress gave us to pay interest on banks’ balances at the Fed, we can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market."

This is like saying: If paying interest on reserves does not work, we will pay interest on reserves.

The only difference is CDs will lock up the reserves for a period of time, while merely paying interest on reserves can be reversed at banks' will.

4) "Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market."

This is essentially the same as options one and two, the difference being the expected duration specifically long-term securities. Once again the Fed's action can be reversed at will.

Triple Counting Tools

Options 1, 2, and 4 are simply three forms of the same hammer, not a hammer, a saw, and a vise.

Option 3 is the same as option zero (paying interest on reserves). Thus of the five tools mentioned, there are really only two, and one of those has already proven to be a failure.

Bernanke concludes with "Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability."

Paying interest on reserves has the actual effect of recapitalizing banks slowly over time. Given that bank balance sheets are a wreck no matter how much banks or the Fed pretends otherwise, and given there is little reason for banks to lend (or consumers of businesses to borrow), the one point I agree with Bernanke on (and it is a key one) it is unlikely that the Fed is going to have to resort to various draining actions anytime soon.

However, when the Fed is forced to do so, the economy is likely to be smashed back into a second (or third) serious recession in a hurry. Indeed the recovery is going to be so weak in the interim, for most consumers it will feel as if the recession never ended. I expect a long period where the economy goes in and out of recession a number of times over a period of years.

Finally, the idea that the Fed (or anyone other than the free market) can "calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability" is preposterous.

The Fed micro-mismanaging interest rates and monetary policy is the primary reason we are in this mess in the first place. If we did not have a Fed, we would not need a Fed Exit Strategy!

Mike "Mish" Shedlock
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