Submitted by Edward Harrison of Credit Writedowns.
Over the past week, America’s banks have had a bumper earning season, in part courtesy of the Federal Reserve’s accommodative monetary policy. Even before this week, a number of market pundits (including me) began to wonder aloud whether the Fed had any strategy with which to remove all of the excess liquidity it has created to deal with the credit crisis. Finally, Ben Bernanke delivered the goods in an Op-Ed in today’s Wall Street Journal, signalling a decent overall strategy (including paying interest on reserves which I outlined here in “S.F. Fed chief Yellen tells inflationistas to pipe down”).
Most of the chatter started after yields on long-dated US treasury securities began to rise, with the 10-year hitting levels over 3.7%. I first mentioned this in my post “How will the Fed withdraw all that liquidity?” after Morgan Stanley’s David Greenlaw made some interesting comment in that regard. As to the specific tools the Fed intends to use, here’s how Ben Bernanke put it (I have added emphasis to the most important bits):
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.
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.
Given the “if necessary” label of the fourth item listed, you should expect Bernanke gave the list in exactly the order of which tools he would prefer to use. But, it should be clear to anyone that the Fed will err on the side of accommodation because it will be loathe to sink any incipient recovery given the dire economic misadventures of the past two years. And since monetary policy acts with a significant lag, inflation is likely to result. Of course, there’s always the pesky problem of all those risky assets now on the Fed’s balance sheet. But, let’s not quibble.
Bonds rallied today because market participants were relieved to find that the Fed had a coherent strategy to deal with the situation. Bernanke’s position as Fed chair is looking a lot more comfortable these days.
Update 2300ET: Just to be clear, I don’t think Bernanke’s strategy is any great shakes. It’s not credible to think the Fed can act with a 9-month time-lag, say, and still be able aggressive in withdrawing liquidity. And the Fed didn’t say anything about the toxic assets on its balance sheet. Nor do I think he said anything substantively or qualitatively different which makes me think the Fed would be able to tamp inflation down. But, that is irrelevant right now because all Bernanke needed to do is make a coherent, plausible exit strategy to meet or exceed expectations. And that is what he has done.
The Fed’s Exit Strategy – Ben Bernanke, WSJ
Bernanke forgot to mention his fifth option:
I will arrogantly use all the authority endowed upon me by Congress in order to beg the Chinese and Russians to continue buying the junk paper that me and my fellows-in-crime bankers print here using our "secret technology". Furthermore, I assure the American public (a.k.a. "chumps") that I shall spare no embarrassment in order to make a buck for myself and my buddies I mentioned above. I shall even resort (as I already have) to prostituting my country's dignity, sell out the future of chumps' children everywhere, and even lie through my teeth, which I assure you I can de with such panache and savoir-faire, it's hardly noticeable anymore. Finally, I now command (and that’s an order, okay!) this chumpy American people I so despise to continue to blindly trust me simply because I deserve it.
That’s the Fed’s fifth option.
Vinny out…. in disgust.
Almost all the money that the Fed and Treasury have pumped into the banking system to re-inflate the burst bubble. Most of it went into a liquidity trap. Some has gone into minor bubbles in the stock and commodities markets. We have seen some inflation in retail energy prices, like for gasoline, but overall no real inflation. To get inflation we would need this money getting out to the wider and being spent. And even that wouldn't be inflationary as long as supply continued to outstrip demand.
So I am at something of a lost to understand why anyone would be terribly interested in inflation. Both the question and Bernanke's answer seem on par with deciding how many angels can waltz on the head of a pin.
My take is this. Ideologues on the right are worried about inflation because they have been wrong about everything else on the economy so why ruin their streak? Bernanke doesn't think that inflation is an immediate concern but he does think that the economy has bottomed out and may start slowly to improve late this year or next year. I think he's wrong. As soon as the Fed and Treasury stop pumping large amounts of free money into the banking system, we will face further deflation. Because Obama et al misallocated resources into an unproductive financial sector we will then have fewer resources to combat that deflation.
Sorry for the dropped words in the above comment.
The conundrum here is that the collateral in the Fed's monetary base is junk, while the liquidity it has to sop up has a decent backstop. It will in effect cost the Fed more than a dollar to sequester a dollar's worth of liquidity. It's going to be very hard to exit this situation – requiring much higher interest rates than usual in this kind of tightening. Another reason to expect a lagging response from the Fed and then an overreaction.
@Vinny G…hope you cleaned your tommy gun after that spray…heh, but have to agree with you.
Whilst most are picking the corn from the peanuts out of this economic excrement were all swimming in, some are still incensed at the rape still in progress, you transcontinental do goody. Watch your ass when confronting customs larikin (oooh you travel allot eh, whats up with that). Been there done that wink, wink.
Any who, GS frat boys are still ruining* amok over the planet with impunity. Bastards need to be taken down before they reconcile their positions and then we can all kiss our freedom (some choice in life) lovin asses good bye.
But it all was to stop the yellow hoard, sniff, your Worship. China was getting to powerful and they bought all our Treasuries sniff, what else could we do (could buy and sell the USA thrice), had to throw them under the bus (SIV MBS). Anglo-Saxon peace lovin presence in the Pacific my ass, arggh hand it over now or meet my Pirate-ly demise.
Skippy…Why did we do Vietnam….ohh yeah, to keep rice pickers from taking over the world, meh fools me thinks, the sky is fallin, we don't own it all!!!! Some things never change eh.
Without the US consumer demanding new money to spend, the US government will continue trying to bridge the gap.
It's a joke that the injections can ever be drained unless you want blood in the streets, this would pull the props out from underneath the world markets.
One way or another expect more currency injections.
China is frantically trying to keep its head above water since they ascribe to the same banking system.
Bernanke has been wrong in the past. His burst of confidence, is predicated on his abilities as financial prognosticator and sage. He is guessing, with no more insight into events unfolding then most of his contemporaries, and some may argue because of his intellectualism, a great deal less sagacity.
But by guessing, even an educated guess, sometimes you end up being tight with right. This may be the case here, as with a law of averages, you can't be wrong all the time. Can you?
If you speak with unflagging confidence, do it often and earnestly enough, people will believe your words and more over won't hold you accountable should those words see the glare of contradicting reality. This is language cons and politicos know and nurture.
Pleasant dreams and a good morrow.
@Anon, 12:33…China is frantically trying to keep its head above water since they ascribe to the same banking system.
That's the big Question, when do they call bluff, cuz fold is not an option and their reality is better suited to the possibility's.
Skippy…Mother of us all, we have been here before, have we not learned any thing at all.
Giving insentives for banks to spend the reserves held at the FED soes not necesarily mean banks will use that money for more lending. They could use it to blow commodity bubbles for instance. I also think the FED might be in a head on confrontation with regulators as the FED wants banks to lend and relax risk controls while regulators what better risk controls in place. Which ever wins spells problems and thats without looking at China which is about to spend some of its dollar reserves. That would mean more dollars floating about, possibly reducing its value making China with its dollar peg more competative in Europe and India.
…all Bernanke needed to do is make a coherent, plausible exit strategy to meet or exceed expectations. And that is what he has done.”- Edward
He didn’t sell me. I still say there won’t be time to remove the “liquidity”. Currency crises happen suddenly. Agree with you that there won’t be 9 months to withdraw it. More like 9 hours. You wake up one morning and read it on the blogs, whoocoodanode?” WSJ, WaPo, etc., pick it up later after editorial board figures out how to spin it.
We define inflation wrongly. When money grows faster than the economy, that is inflation. The solution to the increased “liquidity” is deflation – anathema to everybody in a credit economy. When BB convinces me he’s ready to deflate (of political necessity it may not also contain contraction) then I’ll buy it. BB is a political appointee too. They’ll have his head if it even occurred to him to think about deflation. Given his Keynesian training it won’t.
But even in the best case, the one in which I’m wrong about not being able to remove the liquidity quickly, we face a prolonged economic contraction caused by its removal. What happens when you remove the “stimulus”, heh?
Inflation is the only acceptable solution. This is not an exit strategy. BB’s effort is a bald-faced attempt to manage inflation expectations. If you believe that I’ve got a bridge…
1. Please explain. From where does the Fed get the money to pay the interest on the deposits that it creates for the Reserve bankers in the first place?
2. Does it come out of the money that WE the taxpayers pay to the Fed on the government securities that it creates out of nothing in the first place?
3. Is it not true that the debt-money system of the fractional-reserve bankers REQUIRES ever-increasing quantities of new debts(money) in order to make the debt-service payments on the old debts(money)?
4. If so, then, regardless of the several "policy machinations" of the mastermind Ben, there is no way to create a soft landing from the $$Trillions of heights to which he has taken us.
Please have a read of "How Debt Money Goes broke", and realize that WE are HERE.
A new money system.
The Chicago Plan.
Full reserve Banking.