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Tuesday, August 04, 2009

Bernanke's exit dilemma

Bernanke has the tools to drain liquidity out of the system, but does he have the will to do so? (source: WSJ)

Federal Reserve Chairman Ben Bernanke assured readers of this page ("The Fed's Exit Strategy," July 21) that he has the tools to prevent the huge reserves he's pumped into the banks from generating an inflation that would abort an economic recovery.

But does the Fed have the guts to use those tools? Will it risk censure from Congress and the Obama administration if it tightens money at the crucial juncture when inflationary omens accompany a reviving economy? Mr. Bernanke signaled the probable choice by writing that "economic conditions are not likely to warrant tighter monetary policy for an extended period."

The Fed's past record of judging when and how to use its tools for regulating the money supply is not impressive, particularly in times of economic distress. Its financing of large federal deficits in the mid-1970s sent inflation up to an annual rate approaching 15% before Jimmy Carter repented in October 1979 and installed Paul Volcker at the Fed with orders to kill the monster.

More recently, the Fed's continued easing of interest rates during the 2003 economic recovery created the credit bubble that collapsed last year with such devastation.

The Fed's difficulties in getting money policy right stretch back to its creation in 1913. In 1930 it starved the banks, creating a string of failures that worsened the effects of the 1929 stock market crash. In 1937, it starved them again, contributing to a prolongation of the Depression that had been manufactured in Washington by the clumsy taxation and interventionist policies of Herbert Hoover and FDR.

To be sure, the Fed has had its good years. It financed the 20-year period of low-inflation growth and prosperity that began in 1983 when the Reagan tax cuts became fully effective.

But because of its often self-contradictory double mandate to promote both monetary stability and full employment—plus the rap it has taken from economists like Mr. Bernanke for stinginess in the 1930s—it often overreacts to recessions with excessive generosity. With its federal-funds interest rate target at near zero, the spigots are now wide open. And as Mr. Bernanke promises, they will likely remain that way for an "extended period."

Quite apart from the question of the Fed's will, there is another large issue. Mr. Bernanke's assurances to the contrary, there can be doubts about whether his tools are really adequate to deal with the powerful inflationary pressures the politicians are in the midst of creating in the form of a mountainous and rising federal deficit.

Mr. Bernanke showed that he is well aware of that danger when, in his semiannual report to Congress on July 21, he pleaded with that body to bring the deficit under control. The federal budget deficit is projected at an incredible $1.8 trillion for the fiscal year ending Sept. 30, almost half of proposed federal spending. The Treasury's financing needs will be even higher than that when you count in the various "investments" the government has made in auto, housing and other dubious ventures.

But the day after he issued that plea, President Barack Obama was pleading with the American people to support his nationalized health plan. This plan would yet add hundreds of billions more to the deficit.

The Fed has been financing a significant part of the government's profligacy, and it is riding a runaway horse. Even if it has the means to cope with present financing needs, will it be able to do so when, and if, the economy actually recovers and it has to finance both a recovery and a spending-crazed government?

Martin Hutchinson, a former merchant banker who blogs as "Prudent Bear," wrote in May that the German Weimar Republic was monetizing 50% of government expenditure when in brought on the ruinous hyperinflation that destroyed the mark in the early 1920s. The Fed in May 2009 had monetized 15% of federal expenditures over the preceding six months—well short of the rate that destroyed the German economy, but not negligible.

The Treasury (and Congress) has been depending on the Fed's massive buying of Treasury bonds to keep the government's financing costs within reasonable bounds—as weakening international demand puts downward pressure on bond prices and upward pressure on the interest rate the Treasury must pay. The yield on the 10-year Treasury bond is below where it was a few weeks ago but well above early this year when investors world-wide were seeking the safety of U.S. Treasurys. Even massive Fed support hasn't been enough to prevent slippage in bond prices this year.

The Fed has more than doubled the size of its balance sheet in the last year to over $2 trillion. As of July 30, it held $695 billion in Treasurys, up $216 billion from a year earlier. In addition, it has added nearly half a trillion of mortgage-backed securities it purchased to keep Fannie Mae and Freddie Mac, now wards of the government, afloat.

Adjusted reserve balances of member banks exploded in late 2008, soaring to $950 billion from $100 billion in four months as the Fed has pumped liquidity into the banking system. They peaked at nearly $1 trillion in May. The reserves provide banks with a shield against runs but they also are high-octane fuel for bank lending, which means they can touch off another credit bubble, and the accompanying inflation, when credit demand picks up again.

In his Journal op-ed, Mr. Bernanke listed ways he can keep this monster in check. The Fed can pay interest on the bank reserves it holds. This would lessen the incentive of banks to find private borrowers and keep some reserves out of the credit stream, damping inflation potential. But the net effect would be to add still more liquidity to the system, which would run counter to the longer-term goal of mopping up liquidity.

He said that the Fed could also sell securities to the banks with an agreement to repurchase them, but these "reverse repos" would only mop up liquidity temporarily.

The standard way for the Fed to soak up liquidity, mentioned last on Mr. Bernanke's list, is to sell Treasurys to the banks. That would draw down bank reserves and reduce their inflationary potential. Under the Basel I international banking rules, Treasurys are zero-risk investments and don't have to be matched at 8% of their value with additional capital, as does private lending.

With the huge volume of Treasury financing coming down the road, the Fed will have plenty of bonds to sell (it already has, in fact). But the Fed buys Treasurys primarily by creating new money, or in other words by inflating the money supply. Will it have the nerve or even the capacity to "sterilize" inflation by reselling the bonds to soak up bank liquidity? Again, there are those political pressures. Will the Fed's admittedly bright money managers be able to strike a balance between warding off inflation and leaving the banks with sufficient liquidity to finance an economic recovery?

As to that huge volume of mortgage-backed securities the Fed is now holding, what is to be done with them? They are "toxic," which is why the Fed bought them as a means of keeping Fannie and Freddie solvent. They are "guaranteed" by Fannie and Freddie, which means they now are guaranteed by the U.S. Treasury. So they are yet another liability to add to all the other liabilities being piled on the Treasury. The Fed already has financed them once; will it have to finance them again when they come up for redemption?

In short, there are very good reasons to doubt that the Fed can cope with the political problems of avoiding inflation. The technical problems don't look very easy either.