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.