Wikinvest Wire

The Fed's exit strategy

Monday, April 20, 2009

Anyone who has listened closely over the last few years to what any of the wonks at the Federal Reserve have been saying about what the future holds should be wary of any assurances that inflation will remain under control should "the chain catch the sprocket" as many fear is inevitable, after trillions of dollars have been or will soon be created out of thin air and pushed into the banking system.

John Hilsenrath writes in this WSJ report($) that an exit strategy is right there at the top of the Fed's To Do list, right after saving the global economy from further implosion.

The focus on the issue comes with the Fed's next policy meeting, set for next week. With so many programs already in train, the central bank looks unlikely to take dramatic new actions at the meeting. Assessing signs of improvement in the economy, contingency planning and deliberations on long-term exit strategies are likely to be important parts of the discussions.
Did anyone know the Fed had a policy meeting next week?

With the interest rate pedal nailed squarely to the floorboard for the foreseeable future, Fed policy meetings are not what they used to be, though last month's bombshell about monetizing $300 billion of the national debt (a downpayment on the total amount, to be sure) was certainly well worth the wait.

If today's stock market swoon is a sign of things to come, the nascent fear of future inflation could switch quickly back to fear of future deflation.
Inflation might seem like a distant worry today. Last week, the Labor Department reported that consumer prices in March fell year over year for the first time in 54 years. Rising unemployment and idle factory floors mean businesses have little incentive or capacity to raise wages or the prices they charge customers. There's a risk, in fact, that if the economy weakens much more, the opposite of inflation -- deflation -- could become a serious threat.

That's why the Fed's goal for now is to get inflation higher, not lower. It has effectively been printing money as part of its rescue efforts. When it buys mortgage-backed securities or makes commercial-paper loans, as it has been doing, it electronically credits its counterparty banks with cash in return, which pumps new cash into the financial system.

At some point when the economy recovers from recession, the Fed is going to have to withdraw this money and raise interest rates. Because the Fed is still ramping up many of its programs, the amount of money it will have to withdraw some day is sure to be even higher than today's astronomic levels.
But Paul Kasriel, chief economist of Northern Trust of Chicago, isn't so sure the central bank will get it right. He's not worried about what the Fed has done to date. He's worried the Fed will take too long to make the decision to unwind it.

"The Fed is going to want to make sure that the economy has started on a sustained growth path, and of course there will be a lot of uncertainty about that," Mr. Kasriel says. The real risk, he says, is that the Fed overstays its accommodative policies, "for fear of choking off a recovery."
It's hard to imagine that they will do anything other than err on the side of being too late in fighting inflation for fear of halting the recovery.

That was the lesson of 1937 and, despite the bad precedent set by his predecessor, Ben Bernanke is likely to find that removing accommodation in real time is exceedingly more difficult than it might appear.


getyourselfconnected said...

There is no way the FED will have an exit strategy in the next 5 years. I laid down a money bet with Econbrowser site that FED funds rate will be 0-1% for 3 or more years after the writer was so sure the FED would remove money from the system in due time. Has not taken me up on it as of yet. Anyone else see an FED rate over 1% in the next 3 years? If it is I would argue we will be in some serious trouble (ie dollar collapse) if the FED is FORCED to raise rates!

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