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Will Bernankeís Exit Strategy Work?

The Fedís plan to unwind its current policies will be harder than Bernanke thinks

Marius Gustavson
February 19, 2010

On Wednesday, February 10, Federal Reserve Chairman Ben Bernanke was expected to appear before the House Committee on Financial Services to testify on the Fed’s extraordinary measures taken during the financial crisis, and how the Fed is planning to unwind them. Though cancelled by the “snowmageddon” that hit the DC area, has been published on the Fed's web site.

In response to the financial crisis and economic recession, the Fed resorted to several drastic measures in order to make sure the money supply didn’t contract too much, which it was feared would have led the economy into a deflationary spiral. It also sought to help out the mortgage market through massive purchases of mortgage-related debt, which has dramatically expanded the Fed’s balance sheet.

These measures have more than doubled the monetary base and injected unprecedented amounts of reserves into the banking sector, now standing at approximately $1.1 trillion. So far this massive injection of liquidity has not led to price increases or credit growth, due to the fact that banks are reluctant to lend at a time when both the financial sector and the wider economy are in such a bad shape. However, sooner or later, the time will come when the Fed will have to address the potential for rapid inflation.

Unwinding its current monetary policy is a difficult maneuver: tighten too fast, and the Fed could risk setting off a much dreaded double-dip recession; tighten too slow, and high inflation could result.

Fed officials have long assured the public that they have everything under control. They have an “exit strategy,” they keep telling us, and this will make sure neither scenario comes to fruition. Bernanke says the Fed is “fully confident” they will be able to pull it off:

“Although at present the U.S. economy continues to require the support of highly accommodative monetary policies, at some point the Federal Reserve will need to tighten financial conditions by raising short-term interest rates and reducing the quantity of bank reserves outstanding. We have spent considerable effort in developing the tools we will need to remove policy accommodation, and we are fully confident that at the appropriate time we will be able to do so effectively.” (Emphasis added.)

The main pillar of this strategy is basically to discourage banks from lending by raising the interest rate on their reserve deposits at the central bank, a new policy tool given to the Fed by Congress in October 2008. This, it is believed, would offset any inflationary tendencies in the economy, by curbing credit growth when the economic outlook and financial conditions of the banking sector would otherwise compel banks to start lending again.

Among the many emergency measures taken by the Fed, credit extended to investment banks and insurance giant AIG, as well as purchases of mortgage-backed securities and long-term treasuries has bloated its balance sheet. As economist and Fed-praiser-turned-Fed-critic John B. Taylor points out, the “Fed has financed these program mostly by creating money - crediting banks with reserve balances at the Fed - or by selling other items in its portfolio.”

These reserve balances have expanded rapidly: as of February 3, 2010, they were $1,127 billion, up from $662 billion one year ago. In other words, reserves have nearly doubled in one year, and are far above normal levels. This is why they eventually will “have to be wound down to prevent a significant rise in inflation”, as John B. Taylor writes in his February 10 testimony to Congress, which was supposed to be presented at the Bernanke hearing.

The main item on the Fed’s balance sheet is the program for purchasing mortgage-backed securities (MBSs), which is approaching its targeted goal of $ 1.25 trillion. Taylor shows that “in the absence of the MBS program, reserve balances and the size of the Fed’s balance sheet would already be back to normal levels before the crisis. If it were not for this program, the Fed would have already exited from its emergency measures removing considerable uncertainty about its exit strategy going forward.”

In other words, most of the emergency programs have been gradually ended or are about to expire, something which, according to Bernanke, “should be viewed as further normalization of the Federal Reserve’s lending facilities.” However, the massive intervention into the housing credit market - launched to keep mortgage rates down and cushion the fall in housing prices and the prices of mortgage-related securities – have created huge distortions that need to be corrected at some point in time, as well as a huge potential pitfall for the conduct of monetary policy in the next few years.

This gigantic purchasing program was also a gargantuan mistake, one that needs to be unwound. But the big question is how? If the Fed starts selling off its purchases of mortgage-backed securities, this could create another panic in primary and secondary mortgage markets, setting off a new downturn. Even the prospect of the Fed ending its purchase program in March of this year, creates a large degree of uncertainty in these markets, and any trouble ahead would most likely lead to a call for expanding and extending the program.

Bernanke and the Federal Open Market Committee, which make decisions on the Fed’s policy rate, expects that economic conditions – high unemployment, below-potential output and low inflation - “are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

However, as the late Milton Friedmanreminds us, inflation is always and everywhere a monetary phenomenon. The massive Fed purchases and expansion of the monetary base could very well mean that inflation could hit the U.S. economy sooner than the Fed thinks, and the Fed’s actions have created a potential for huge and rapid price-growth, once inflation sets in.

In order to avoid a second “Great Inflation” like the one in the 1970s, the Fed relies upon its newly designed and untried strategy of adjusting the interest rate on bank reserves upward, which according to Fed officials will “limit the demand for credit.” The rate is currently 0.25 %. How high this rate has to go in order for the Fed’s plan to actually work, no one knows yet.

There are several problems with this “exit strategy,” not the least of which is the overconfidence on the part of Bernanke and his colleagues that they will get it right. Over-confidence, both among Federal Reserve officials and financial market actors in the years leading up the crisis, based on the belief that the Fed would always be able to come to the rescue and do the right thing, was one of the things that got us into this mess in the first place.

There is a certain hubris to all this: Even if Fed officials have the right tools, how would they know exactly how to exit in which timely fashion? And how would they know which interest rate would be right?

Monetary historian and author of The History of the Federal Reserve, Alan H. Meltzer, thinks the Fed’s anti-inflation exit strategy will fail. As he writes in The Wall Street Journal:

“Federal Reserve Chairman Ben Bernanke has explained his exit strategy to prevent future inflation. The Fed recently began to pay interest to banks on the reserves they hold in their vaults. Using this new tool, it claims the ability to get banks to keep the money instead of lending it out, thus containing the money supply and inflation… I don't believe this will work, and no one else should.”

The main problems with the exit strategy are that the Fed is trying to exit from unchartered territory, using new, untried tools, and to top it off, being forced to do so under highly uncertain circumstances, both in the domestic and global economy. The high degree of uncertainty makes it unsure how the financial sector and the wider economy will react to the exit measures. Also, as Meltzer points out, once financial conditions start to improve, it will be too tempting for banks not to start lending again. After all, this is how banks make money.



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