The Chairman of the Federal Reserve Ben Bernanke has outlined his anticipated exit strategy, providing a sneak peek into the Fed’s kitchen, as the Fed’s cooks stir the broth. This strategy has been released to the public on the Fed’s public website and to the news media before he has had the chance to testify in front of the Committee on Financial Services of the U.S. House of Representatives because of the bad weather, with portions of that strategy available for public comment in the Federal Register as his released prospective testimony indicates. This is good news suggestive of a more transparent Fed. It would be nice if not only the Federal Register, but the entire legislative process is more open to the public in a more structured manner for public comment as legislation, not merely regulations by federal agencies, is being made. But that is an issue for another day.
Bernanke’s testimony reveals the Fed’s intention to prepare the markets for the withdrawal of the current monetary accommodation which is a mishmash of a variety of facilities created by the Fed to get money to the markets in a hurry beginning in the second half of 2007. Even though that is now water under the bridge, the Fed’s efforts to pump money into the markets in a time crunch having been appreciated but not its helter-skelter approach to do so, it would be useful to apply the lessons learned in the last two years to withdrawing the money supplied.
The Fed Chairman says, “[t]he FOMC anticipates that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” This is sound policy, provided he can get rid of the agency debt and mortgage backed securities (MBS) on the Fed’s balance sheet first, which is unlikely to happen until the economy recovers.
The non-functionality of the federal funds market in which excess reserves are traded to set the federal funds rate is clear per his accurate description of it in the context of the large volumes of excess reserves when he says that “[t]he Federal Reserve’s purchases have had the effect of leaving the banking system in a highly liquid condition, with U.S. banks now holding more than $1.1 trillion of reserves with Federal Reserve Banks. As a result of the very large volume of reserves in the banking system, the level of activity and liquidity in the federal funds market has declined considerably, raising the possibility that the federal funds rate could for a time become a less reliable indicator than usual of conditions in short-term money markets.” So, the Fed’s first priority must be to return the federal funds market to normal functionality.
The process of doing so is exactly the opposite of what the Fed is trying to do. It must not “[communicate] the stance of policy in terms of another operating target, such as an alternative short-term interest rate.” The Fed is describing this alternative short-term interest rate, even though it says it has not made a decision on it yet, as “the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, while simultaneously monitoring a range of market rates” the goal being normal reserves balances to return the federal funds market to its pre-crisis condition. The best mechanism to drain the reserve balances is to let the reserves out to be put to work toward economic recovery by stopping interest payments on the reserves or for other purposes more aligned with financial regulatory reforms while also serving the purposes of national security and foreign policy.
The best course of action for the Fed, at all times, crisis or no crisis, is the standard operational framework of monetary policy of buying and selling treasury securities to expand and contract money supply respectively, while using better structured discount window operations to engage in resolution mechanisms to support the banking sector or the non-commercial banking financial sector in the future, should that part of the financial markets come under the government’s regulatory reach.
Toward this end, first, the Bernanke Fed must explicitly convey to the markets the measure (the Bureau of Labor Statistics’ Consumer Price Index or the CPI) and level of inflation it is willing to tolerate against that measure (or the percentage annual change in the CPI, as measured January to December of every calendar year). Second, it must work with the Congress and the administration to decide on a course for the excess reserves (see other cross-referenced articles above) rather than attempting to change its current minimum reserves requirements for its member banks to return the reserves market to normalcy either through interest rates on the reserves or by raising the reserve requirements or some combination of both. Third, when economic conditions are suitable, the Fed must gradually raise its federal funds rate. Finally, after the economy recovers, it must dispose off its agency debt and MBS holdings in a manner beneficial to the Fed’s (and hence the Treasury’s) bottom line.