The Future of Monetary Policy: The Exit Strategy

The recession seems to be ending. However, many people do not feel that the recovery will be very robust. (See my post “Is the Recession Over?” http://maseportfolio.blogspot.com.)
The crucial claim in the near term though is that the recession seems to be ending.

Because of this the issue that seems on the minds of many people is: how is the Fed going to remove all the bank reserves it has pumped into the banking system over the past ten months? The obvious concern is that the recessionary downdraft would turn into an inflationary nightmare. In other words, these people are asking for an explanation of the “exit strategy” the Federal Reserve plans from its policy of preventing a major economic collapse?

Chairman Bernanke spoke to Congress last week to give some assurance that the Federal Reserve knew what it was doing and would, therefore, do what it needed to do as the economy recovered to keep country from experiencing a wicked bout of inflation. I did not sense a lot of confidence that the hypothesized “exit strategy” would unfold as Bernanke stated that it would.

Bernanke also claimed that the United States economy, although it would begin recovering from the recession soon, would not emerge rapidly. Consequently, the Federal Reserve would have to keep its target Federal Funds rate at the present levels for an extended period of time.

There are two immediate concerns with Bernanke’s presentation. First, the Federal Reserve always tends to react to the economic situation. It does not lead economic events. Simply put, the Federal Reserve will not move in advance of any evidence that inflation is picking up. It will follow such evidence. Furthermore, can you see this Federal Reserve taking on Congress by saying that it is tightening up on monetary policy when economic growth is still moderate or just tepid and unemployment rates are above 8% and inflation has not began to accelerate? This Fed does not have that independence from the political side of the government.

Second, even if inflation does begin to pick up speed increasing rapidly enough to cause some concern in financial markets, can you see Congress accepting an inflation target versus a target for faster economic growth. At no time in post-World War II history has the Federal Reserve crossed a presidential administration or a Congress in the early stages of an economic recovery to follow an anti-inflationary period. This starts right with the “Accord” of 1951 to the present. (The Volcker reign at the Fed does not qualify for this as its timing in the economic cycle was not the same.) The Employment Act of 1948, and as modified, still rules as far as Presidents and Congresses are concerned.

Plus there is the concern over the federal deficit. There will be some form of health care coming along, and an energy policy, and other policy initiatives that will continue to put pressure on the budget of the government. The prospect for further large deficits and a rapidly growing national debt is still a reality that must be faced in the next few years. How is the Federal Reserve going to stay independent of all the Government bonds that are going to be coming to market?

This kind of environment will also encourage private borrowing again, both from businesses as well as the consumer. This kind of environment is inflationary like the early 2000s even if price indices like the Consumer Price Index do not rise dramatically. With private debt soaring along with the debt of the government we will have another period of “credit inflation.”

When the growth of credit exceeds the possible real growth of the economy or if the growth of credit in a particular sector of the economy exceeds the possible real growth of that sector, there is a “credit inflation.” This “credit inflation” can result in an asset bubble as occurred in the housing market earlier this decade where asset prices rose even if “flow” prices, like rents, or, implied rents as estimated for the Consumer Price Index, do not reflect this inflation. In addition, it can result in a substantial deficit in the trade balance and lead to a massive flow of dollars into world financial markets and whether these imbalances in the United States trade deficit will find happy recipients of the dollars, as China gladly seemed to receive dollars earlier on, is a question no one can answer at this time.

There is too much debt already in the financial system and it needs to be reduced. The Fed is trying to do the best it can and I don’t question the “good intentions” of the people that are attempting to get us through this mess. However, the problems are huge and I am not convinced that having good intentions is sufficient to lead us through these times. There is plenty of evidence that there is plenty of pain ahead of us. I am not convinced that Ben Bernanke is the person to create this pain and then lead us through the restructuring of the economy.

The Reappointment of Ben Bernanke to the Chair

There are two reasons I am not in favor of re-appointing Ben Bernanke as Chairman of the Board of Governors of the Federal Reserve System. First, I don’t believe that Bernanke has a plan on how to move the country into the future and I don’t believe that he ever did have a plan to move the country into the future. He was an advocate of “inflation targeting” and a student of the Great Depression. It is not the right time in history to pursue “inflation targeting” and the only thing Bernanke learned from the Great Depression is that if you are going to do something to try and combat a major economic downturn, do it in sufficient magnitude so that no one can say that you erred on the side of doing too little effort.

Second, I believe that the economy is going to have to go through some pain in the near future, a pain that results from the problems related to having too much debt in the economy. To restructure the balance sheets of American finance and industry there are still tough times to go through. I don’t see Ben Bernanke as the inflictor of pain. Paul Volcker was capable of acting in that way and had the personal strength of character to carry it through. Bernanke, in my mind, has neither the ability to inflict discipline on the economy nor does he have the weight of personality to carry it through.

Let’s look at Bernanke’s history. He was complicit with the Greenspan easy money policy that kept interest rates at historically low rates for too long a period of time and created the “credit inflation” that resulted in the housing bubble, the dramatic decline in the value of the United States dollar by about 40%, and the massive flooding of dollars into the world economy. He had no feeling at all for the lending practices in the mortgage sector or for the mess that was evolving in the area of credit derivatives and banking governance. Later on, he continued to follow a policy of fighting inflation when the financial markets were beginning to fall apart. He seemed to react hastily in September 2008 and was not a consistent guide through the bailout of Fannie Mae and Freddie Mac, the collapse of Lehman Brothers, and the strange subsidization of AIG. (See my post of November 16, 2008: http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.)

I do not know who should replace Bernanke at this time. All I do know is that we have a new administration and a new economic team. Bernanke, I believe, does not have what it takes to get the financial and monetary situation straightened out. I believe that President Obama needs to appoint his own choice as Chairman of the Board of Governors of the Federal Reserve System.