Bernanke outlines Fed’s easy money exit strategy
Over the past week, America’s banks have had a bumper earning season, in part courtesy of the Federal Reserve’s accommodative monetary policy. Even before this week, a number of market pundits (including me) began to wonder aloud whether the Fed had any strategy with which to remove all of the excess liquidity it has created to deal with the credit crisis. Finally, Ben Bernanke delivered the goods in an Op-Ed in today’s Wall Street Journal, signalling a decent overall strategy (including paying interest on reserves which I outlined here in “S.F. Fed chief Yellen tells inflationistas to pipe down”).
Most of the chatter started after yields on long-dated US treasury securities began to rise, with the 10-year hitting levels over 3.7%. I first mentioned this in my post “How will the Fed withdraw all that liquidity?” after Morgan Stanley’s David Greenlaw made some interesting comment in that regard. As to the specific tools the Fed intends to use, here’s how Ben Bernanke put it (I have added emphasis to the most important bits):
First, 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. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.
Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline.
The Treasury has been conducting such operations since last fall under its Supplementary Financing Program. Although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.
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.
Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.
Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.
Given the “if necessary” label of the fourth item listed, you should expect Bernanke gave the list in exactly the order of which tools he would prefer to use. But, it should be clear to anyone that the Fed will err on the side of accommodation because it will be loathe to sink any incipient recovery given the dire economic misadventures of the past two years. And since monetary policy acts with a significant lag, inflation is likely to result. Of course, there’s always the pesky problem of all those risky assets now on the Fed’s balance sheet. But, let’s not quibble.
Bonds rallied today because market participants were relieved to find that the Fed had a coherent strategy to deal with the situation. Bernanke’s position as Fed chair is looking a lot more comfortable these days.
Source
The Fed’s Exit Strategy – Ben Bernanke, WSJ
You noted there has been widespread doubt whether the Fed had any exit plan and you now call Bernanke’s proposals ‘a decent overall strategy’.
Well, perhaps it is. But, really, is there anything new at all in his four points? If not, how can this possibly be a great strategy? Everybody and his donkey could have thought up these four points, I’d say. Certainly all the financial pundits could – and in all likelihood they did. Yet in spite of that, they kept moaning about a missing exit strategy – and rightly so. Clearly, that must mean that all those regular tools which those pundits could think of, did NOT constitute a viable exit strategy in their view. Yet now all of a sudden when the greatest donkey of all brags about exactly those same tools again and how great those will do the job, that would constitute briliant thinking showing the safe way out?
On a related note, in all those repos the Fed is supposed to do, and the treasuries and securities it woul sell – just what exactly does it think it can repo with and what it can sell off? Bernanke just said today (7/22) the Fed will soon (don’t remember his exact timeline) have +less+ treasuries on its balance sheet than it had two years ago before the crisis started. Yet for an exit strategy to be effective it will have to sell massive amounts of – well, what? The Fed will find itself equally massively wanting of treasuries (and then some), since it has swapped the ones it once had out to the banks at the start of the crisis, in return for all the banks’ toxic nonsense – which has been loading up the Fed’s balance sheet ever since. Are we to believe the banks are going to buy that crap +back+ from the Fed (instead of the treasuries it doesn’t have) in return for all the cash those banks have been so desparately hoarding?? Seems highly unlikely. Ergo: the Fed just has not enough quality assets to repo or sell off.
So that would leave the Fed only with paying interest to the banks on their reserves at the Fed. I haven’t done the math but something tells me that is a ridiculous measure in view of the huge task it needs to accomplish.
Oh yes, and then there still are those treasuries the treasury is supposedly going to sell for the explicit purpose of +not+ using the money it will generate, and instead dropping it dead at the feet of the Fed. Surely, after all the massive amounts of debt the treasury is already struggling to sell, it would not at all be problematic to sell yet another similarly massive amount, would it?
In short: not only is the Fed’s ‘strategy’ hopelessly inadequate old news, but the Fed doesn’t even have the beef to execute it.