Bernanke Outlines the Fed's Exit Strategy

Wednesday, July 22, 2009

On Tuesday Treasury markets signalled re-emerging confidence that the Federal Reserve may be able to absorb the oceans of liquidity it has pumped into markets in the last 2 years. The nice rally across the curve based on an OpEd piece by Fed chairman Ben Bernanke in the Wall Street Journal.
As the investment world has grown wary of the explosive growth of the Fed's balance sheet since last September Bernanke stressed the argument that this has helped to mitigate the problems in the economy. According to Bernanke historically low Fed funds rates will be with us as long as there is a recession, but the Fed acknowledges the need to raise interest rates to avoid higher inflation.
Looking at such key indicators like industrial production and the labor market I am left with the question when we will see growth in the USA again. Bernanke did not specify any time frame for the recovery.
The Fed head also pointed out that he has an arsenal of tools to tighten monetary policy despite an inflated balance sheet:
Even if our balance sheet stays large for a while, we have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination.
Citing the ECB, Bernanke sees a way to put a floor below short term rates.
Considerable international experience suggests that paying interest on reserves effectively manages short-term market rates. For example, the European Central Bank allows banks to place excess reserves in an interest-paying deposit facility. Even as that central bank’s liquidity-operations substantially increased its balance sheet, the overnight interbank rate remained at or above its deposit rate. In addition, the Bank of Japan and the Bank of Canada have also used their ability to pay interest on reserves to maintain a floor under short-term market rates.
4 Tools to Tighten Monetary Policy
Bernanke argues that the Fed has 4 more tools to drain excess liquidity:
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.
Don't expect any tightening soon, though:
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.
While outlining the Fed's strategy is a good guide for the future, the big "if and when the economy recovers" does not get answered by Bernanke. The lending spree in this decade has turned a good part of the US population into debt servants who will likely look into more savings and paying off their loans before the hailed US consumer will find a few notes in her/his wallet to go on the next shopping marathon.
Looking at bankrupt California, tent cities across the nation and the sharp drop in industrial production these indicators show no signs of a recovery anytime soon.


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