The Fed’s (lack of) Exit Strategy

Bernanke explains the fed's exit strategy in the Wall Street Journal.

(emphasis mine) [my comment]

JULY 21, 2009, 8:13 A.M. ET
The Fed's Exit Strategy

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. [Translation: We, at the Fed, have created ("printed") an enormous amount of money)]

These actions have softened the economic impact of the financial crisis [Translation: we, at the Fed, are doing a really good job]. They have also improved the functioning of key credit markets, including the markets for interbank lending, commercial paper, consumer and small-business credit, and residential mortgages.

My colleagues and I believe that accommodative policies will likely be warranted for an extended period [Translation: Bernanke doesn't expect inflation]. 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.

To some extent, reserves held by banks at the Fed will contract automatically, as improving financial conditions lead to reduced use of our short-term lending facilities, and ultimately to their wind down. Indeed, short-term credit extended by the Fed to financial institutions and other market participants has already fallen to less than $600 billion as of mid-July from about $1.5 trillion at the end of 2008. In addition, reserves could be reduced by about $100 billion to $200 billion each year over the next few years as securities held by the Fed mature or are prepaid. However, reserves likely would remain quite high for several years unless additional policies are undertaken.

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.

Congress granted us authority last fall to pay interest on balances held by banks at the Fed. Currently, we pay banks an interest rate of 0.25%. When the time comes to tighten policy, we can raise the rate paid on reserve balances as we increase our target for the federal funds rate.

Banks generally will not lend funds in the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve. Moreover, they should compete to borrow any funds that are offered in private markets at rates below the interest rate on reserve balances because, by so doing, they can earn a spread without risk.

Thus the interest rate that the Fed pays should tend to put a floor under short-term market rates, including our policy target, the federal-funds rate. Raising the rate paid on reserve balances also discourages excessive growth in money or credit, because banks will not want to lend out their reserves at rates below what they can earn at the Fed.

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.

Despite this logic and experience, the federal-funds rate has dipped somewhat below the rate paid by the Fed, especially in October and November 2008, when the Fed first began to pay interest on reserves. This pattern partly reflected temporary factors, such as banks' inexperience with the new system.

However, this pattern appears also to have resulted from the fact that some large lenders in the federal-funds market, notably government-sponsored enterprises such as Fannie Mae and Freddie Mac, are ineligible to receive interest on balances held at the Fed, and thus they have an incentive to lend in that market at rates below what the Fed pays banks.

Under more normal financial conditions, the willingness of banks to engage in the simple arbitrage noted above will tend to limit the gap between the federal-funds rate and the rate the Fed pays on reserves. If that gap persists, the problem can be addressed by supplementing payment of interest on reserves with steps to reduce reserves and drain excess liquidity from markets—the second means of tightening monetary policy. Here are four options for doing this.

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 securit ies back at a slightly higher price at a later date. [Reverse repurchase agreements are meant for fine tuning the money supply. They become more expensive the higher inflation is and the more they are used. As such, They are not a useful tool when the fed needs to shrink if balance sheet by over a trillion]

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 is already having trouble finding buyers for all the debt it needs to sell, and this job will become even more difficult as inflation picks up. There is no way the Treasury will be able to sell extra debt to make deposits with the Fed]

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. [The Fed is already paying interest on bank deposits. If it needs to increase raise these interest rates on these deposits, where will it get the money to make interest payments? (printing press)]

Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market. [Who will buy these long-term securities?]

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.

Overall, the Federal Reserve has many
[no] 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.

The Seattle Times reports that ten questions we'd really like to have Bernanke answer.

July 21, 2009 at 10:00 AM
Ten questions we'd really like to have Bernanke answer
Posted by Jon Talton

Top of the News: Fed Chairman Ben Bernanke is testifying before Congress today. It's the usual snoozer that will get little attention unless he says something like "run for the bomb shelters, your bank accounts are worthless!" Here are some questions I wish could be answered for We the People:

1. Why has the Federal Reserve been so secretive about the real amount and the beneficiaries of perhaps trillions of dollars in lending facilities and other assistance beyond the TARP program? Who are these institutions and how did they use the money? How do you respond to the inspector general's report that the liabilities are $23.7 trillion, the program has been badly monitored and much of it was used by banks, not to lend but to grow bigger?

(after Bernanke recovers from fainting and is hauled back into the witness chair)...

2. Was the Fed stupid or complicit in failing to see the risks from the housing bubble and take appropriate regulatory and monetary action? This is a simple question, Mr. Chairman.

3. Did you and President Bush's Treasury Secretary Henry Paulson (and then New York Fed President Tim Geithner, now Treasury secretary) stampede this Congress into the poorly crafted bailout last fall? Why, more than a year after the August 2007 swoon, didn't the Fed and Treasury have a more thoughtful, effective and accountable emergency strategy in place?

4. So Bear, Sterns and Lehman Brothers just snuck up on you? Does this show that the Fed is A) Captive of the conventional economic wisdom that brought on the crash, and/or B) Captive of the most powerful Wall Street institutions? And while we're on the subject, tell us again about who made the decisions about who would live and die, Bear vs. Lehman, and the consequences for the economy?

(Chairman Bernanke passes out again. Is given a cold glass of water, his tie loosened, and replaced in the chair)...

5. Does this "exit strategy" to avoid turning the massive monetary stimulus into inflation take into account the still large debt overhang on the American economy, the trillions in dollars and debt held by China and the petro-states, and China's efforts to replace the dollar as the world's reserve currency? Or will that be another Lehman-like oops moment? [it will be another Lehman-like oops moment]

6. You are America's foremost scholar on Federal Reserve policy during the Great Depression. Are you concerned that today we have not established a Pecora Commission, which in the 1930s called the "banksters" to account and laid the groundwork for regulation that avoided a repeat of the disaster until it was repealed in 1999?

7. Why did you allow institutions that are already so large that they pose a systemic risk to the entire economy to grow even larger during the crisis, thanks in part to taxpayer money?

8. Foreclosures continue to increase and Congress has done nothing to help average house owners -- it's done as little as possible to stop predatory credit-card practices. Meanwhile unemployment keeps rising. Wages have gone from stagnation to retreat and many Americans have lost their retirement nest eggs. This is very different from the Depression, when the banks were tightly reined in and average people received help if they needed it. Do you believe it's sustainable to have a coddled financialized economy on the one hand, and a struggling, deindustrialized average American economy on the other?

9. Why did federal regulators allow Goldman Sachs, an investment bank, to become a bank holding company? As you more than anyone knows, this violates the hard-won wisdom of the Depression, where investment and commercial banks were separated to prevent a repeat of the 1920s speculation. Doesn't this add considerable risk to the system, including the FDIC? Are you concerned about moral hazard, as Goldman ramps up its "innovations" -- now with the sure knowledge that taxpayers will foot the bill for any big mistake? It's now clear that Goldman was not in deep trouble last fall -- it had made a killing on the bubble, then sold short to make more on the crash. Did regulators realize this?

My reaction: Spiking commodity prices (as a result of a default on the futures market) will not only dirve up inflation (gas, food prices, etc), they will cause interest rates to soar.

Spike in commodity prices will cause treasuries to crash

When commodity prices spike, it will cause selloffs in US credit markets:

A) Central banks around the world will start selling US reserves to appreciate their currencies and contain domestic inflation
B) Investors, especially those expecting deflation, will panic and sell treasuries

Now, supply is ALREADY overwhelming demand in the treasury market. If half of today's buyers become sellers, short term treasuries are going to crash. Treasury actions will fail.

Fed will face collapsing credit markets and skyrocketing inflation

The Fed's will face collapsing credit markets and skyrocketing inflation at the same time. All the options in the Fed's current Exit Strategy would prove useless in this scenario.

This entry was posted in Currency_Collapse, Federal_Reserve, News_Developments, Wall_Street_Meltdown. Bookmark the permalink.

12 Responses to The Fed’s (lack of) Exit Strategy

  1. Jeff Burton says:

    Slightly off-topic, but how is anonymous feeling about his/her call for 82.5 on the DX today?

  2. Jeff Burton says:

    So you'll still be hanging around here if the dollar hits 70? 60? Just want to make sure you are available for a repast of corvid.

  3. ronin says:

    anonymous is a moron and lives in his own delusional world. either that or he's been bought off just like the feds. do us a favor and go read your cnbc and swallow the blue pill, idiot.

  4. VegasBD says:

    Obama vs Obama on the stimulus package and unemployment projections meet reality


  5. ronin says:

    to anonymous: yeah, keep your money in the dow and see what happens to your money, dirtbag.

  6. Numonic says:

    Anonymous said...
    But something tells me the sales will go good, for remember no currency, nor metal, is as liquid as the dollar - despite what the doomsters say.

    1. Why are people like you assuming that America was born yesterday? Our problem is not the new debt we're trying to sell, it's all the past debt that we've accumulated that is coming due and defaulting due to the overstretched dollar. The selling of new debt is just a small tool to get cash to try to stop all that past debt from defaulting(the govt. sells these T-Bonds to pull cash out of circulation to help throw at the credit market for the purpose of stopping defaults: ponzi scheme) but it seems you have no idea of how much past debt there is that is coming due(over 1 quadrillion dollars). You also seem to be unaware of the amount of cash held abroad(a few trillion at most). It's no where near the amount needed which is why the Fed is doing most or all of the buying of the debt. The govt. can't ask people for something that doesn't exist so they have to print and create it themselves. The US is experiencing massive defaults. Has the definition of "liquid" changed?

    I don't know if you're the same Anonymous that replied in the "leading-newsletter-paints-grim-picture" blog and said "But as it stands right now, and even in the for foreseeable future, there is nothing that can match the liquidity of the dollar. Nor is there a system in place that can replace the dollar this very, or again the the foreseeable future, instant."

    but I'll reply the same:

    "Aren't dollar debt/bonds defaulting more than any other bonds right now? How can someone say the dollar is liquid? The credit contraction goes against that. If the dollar was liquid we wouldn't be having a credit contraction. China's currency is more liquid than the dollar. It's having no problem expanding it's credit. I would say the dollar is the most ill-liquid currency right now because of the enormous debt deleveraging going on."

    "But i wouldn't suggest moving in to China's currency because it too will suffer devaluation even after the dollar defaults on all it's debt. It will suffer devaluation because even though other currencies will be defaulting, China's economy even after the stimulus' will still be in shambles and more stimulus and importing will be needed to stimulate and save domestic demand. Problem is the rest of the worlds manufacturing sector is poor and what China needs, the rest of the world doesn't have. So China will be trying to import enough to satisfy it's domestic demand but it will fail because there won't be enough in the rest of the world to do that. And with all those Chinese dollars chasing not enough products, the value of the Yuan will devalue."

  7. James says:

    We have some predictions of 1,000 DOW and 10,000 DOW in the near term by some intelligent people out there, but no one can predict the future as these are unprecedented times. There is a good chance that the stock market can continue to rise given the huge stimulus package, with a second one coming down the pipe soon, and all that printed money going to financial institutions and infrastructure companies. No one can predict whether we will have big time inflation or deflation, but gold does perform well in both scenarios. We can't say the same of the stock market, or the USD. Here is a video for everyone, what are your thoughts??? Golden Opportunity??

  8. Mark says:

    My best guess is that out there most people think the stimulus starts to work. And it supposedly pushes up the dow. Maybe it is a self-fulfilling prophecy/assumption.

    The real US goes the other way. My guess is that either filled to the top oil reserves or the US financial projections coming out in mid August are potential events leading to the next BIG leg down in the dow. Maybe both.

    I'll start to go short oil soon. Maybe I'll be all short oil in early or mid August.

  9. Numonic says:

    Anonymous said...
    Dear Numonic,

    When ask the question: "Aren't dollar debt/bonds defaulting more than any other bonds right now?" I have to wonder what you mean exactly.

    For example, when we talk of Government debt, which is sold on the market via treasury sales, it should be noted that none of those treasuries have been defaulted on.

    Thus when you talk about debt which has been defaulted on you are in fact not talking about Government but consumer and corporate debt.

    Please, in the future, don't try to conflate the two just to support your idea that the dollar is doomed.

    It makes no difference. I don't know why people choose to seperate public debt and private debt. Both are debt for the same currency. So the debt defaulting isn't because people just woke up and chose to no longer extend credit to those companies, the debt is defaulting because there is a shortage of dollars and companies CAN NOT extend credit. It's fools who assume that this credit contraction is happening because people are choosing to make it happen. As if people just woke up one morning and said, "you know what i'm going to stop giving my money to these people but i will continue giving it to the govt." WAKE UP!!! This credit contraction is caused by a shortage of dollars. This shortage of dollars will effect ANY promise to deliver dollars and that includes Treasury Bonds.

    I know i said something like this before in another of Eric's blogs so i went to find it and behold here it is. I said it in the "*****The Amazing Correlation Between US Secretaries Of The Treasury And Gold Prices***** " blog.

    I said:

    "I was originally going to write about how Mike "Mish" Shedlock is so wrong about Treasury Bond Yields remaining low. He seems to believe that every other bonds yields will rise as thos bonds default and that it is an impossibility for Treasury Bonds to default. This is rediculous because Treasury Bonds return the same currency as all those other bonds that are defaulting. Why would all those other bonds default but the Treasury Bond won't? Why, because the govt. has direct access to the currency with the printing press. This is foolishness, the Treasury Bonds are just as in trouble as any other bond/debt/stock/fund or anything that promises to deliver the currency. The Fed and Govt. does not have control of Treasury Yields, and they proved that when yields started accelerating higher some short time ago and is continuing to move higher. The silliness is that Mish's explanation for the rise in Treasury yields was that maybe the decline in the economy was decreasing in speed. Mike "Mish" Shedlock the person who keeps telling us how bad the economy is see's yields move up on the treasury and instead of equating the yields moving up in treasuries as a sign of defaults and a worsening economy like he does when he talks of corporate or municipal or other bond yields rising, instead he says that the rise in Treasury Yields is maybe due to the economy declining in a lesser speed. This guy is full of it. He is right about how the economy is in the $hitter and will get worse but he contradicts himself and refuses to accept that Treasury Bond yields can rise without a recovering economy. When corporate/municipal bond yields rise, he says it's a sign of a worsening economy, when treasury bond yield's rise he says it HAS to be a sign of a recovering economy. BS."

    I'm sure I said something similar in other blog's of Eric's too. It doesn't matter if it's private or public debt, they are both promises to deliver the same currency which is in shortage due to the massive amount of debt(over $1 quadrillion) that has stretched the dollar thin.

  10. Numonic says:

    "Now as to why the dollar is more liquid then anything on the market at this time?

    That is elementary...

    One, the dollar is the reserve currency of the world currently (and will be for sometime to come).

    I'm sorry but that is stupid. You need to look up the definition of "liquid". US credit is contracting, that's the opposite of liquid. US debt is defaulting, that's the opposite of liquid.

    The US used to be liquid which is why it was the world reserve currency but today we are witnessing an end to that.

    You can not sit there and tell me that US is more liquid than China. The US is a debtor nation, China is a creditor nation. That's elementary.

    "And two, given this status the dollar can be converted into almost anything... meaning that it can buy goods, services, labor, metals and other currencies throughout the world!

    Not for long.

    "Again why?

    Because the dollar is accepted by everyone - even those that bitch about the dollar being the world reserve currency (thus asking the world to get the balls to change this, for example replacing the dollar with IMF SDRs bonds).

    If I promise to give you something and fail to deliver it, will you continue to accept my promise? This is where US stands right now. And the strenth of our bonds isn't dependent on whether it's accepted or not, it's dependent on whether it's liquid(pays out) or not. The US credit is contracting and has debt(promises for those dollars) defaulting. This is the opposite of liquid. The Treasury Bonds are no different than any other bond/promise to deliver dollars. Even if it doesn't suffer default(which i believe it will anyway, but even if it doesn't), it will be effected by the massive default of other promises to deliver dollars. Because it's the same currency(which is in shortage) that it is promising to deliver. The more promises to deliver dollars default, the more risky other promises to deliver dollars look. Which is why the govt. is doing everything in their power to try to stop the defaults of these other debts. Because the defaults of those other debts for dollars will effect the risk status of other debts for dollars(including Treasury Bonds).

    "America will not default and before it does I can assure that WWIII will likely occur.

    I mean think of it, America has over 750 military bases around the world. Why do you think America needs so many bases for?

    I'll tell you. It's to ensure the political and dollar hegemony of America, and to a lesser degree the political hegemony of the entire Western world."

    This is the dumbest thing i've ever read! Can the army make all the promises for dollars that were accumulated over the decades disappear without anyone noticing? Because that is basically what you're saying they can do. What you don't understand and need to understand is that the US had a force that was more powerful than it's army. You know what that force was? That force was "credit". Yes "credit" robbed and looted more around the world than any army ever has. And now that credit is coming to an end, the looting and stealing will come to an end.

    The world will be better and more prosperous for it. The global credit collapse is the beginning of global prosperity. So celebrate!

  11. ronin says:

    numonic: don't bother with anonymous. i don't think even he believes his bull. he's one of those idiots that takes other ppl's money, invest it in crap and make money off of it(by fees) and think he's smart. when those who fall prey to his nonsense puts their money in the dow, he'll be busy shorting.

  12. Nasty comments by "Anonymous" will be deleted.

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