October 21, 2012
Recovery and the Fed's 'Exit Strategy'By Jon N. Hall
Since the 2008 financial crisis, the Federal Reserve's policy has been to keep interest rates at about zero percent, and to run a program called "quantitative easing" (or QE), which is designed to pump money into the system by buying U.S. Treasury bonds, mortgage-backed securities, and other assets. These policies will someday need to be reversed (or unwound) in order to prevent "price inflation." This reversal of policy consists of raising interest rates and selling the Fed's recently acquired assets. It is called the Fed's "exit strategy."
As early as 2009, critics warned about the difficulties of the Fed's exit strategy and its potential for failure in preventing price inflation. After a speech by Fed Chairman Ben Bernanke at the London School of Economics, the British newspaper The Telegraph on January 13, 2009 reported:
Mr Bernanke is acutely aware of critics who fear that the Fed is storing up trouble by "printing money" and stoking a Zimbabwe-style surge in the US monetary base. "At some point, the Federal Reserve will have to unwind its various lending programmes," he said. This will happen in an orderly fashion. The excess liquidity poses no inflation threat because the "great bulk" is lying idle on deposit at the Fed. It will be mopped up "automatically" as markets revive.
In July of 2009, as the economy started to improve, economist Lawrence Kudlow in "Is Bernanke Wise Enough to Exit?" at Real Clear Markets wrote:
A third-straight rise in the Index of Leading Economic Indicators points emphatically to recovery and an end to the recession. Strong profits at companies like Apple, Caterpillar, Merck, and Starbucks suggest that "someone, somewhere, somehow is spending money," in the words of Wall Street blogger Douglas McIntyre. Or maybe the Fed's liquidity mustard seeds are finally germinating.
By "the Fed's liquidity mustard seeds," Mr. Kudlow was surely referring to QE1, the Fed's program of buying $1.25T in mortgage bonds launched in March 2009. With the economy showing signs of "green shoots," Dr. Larry wrote that Bernanke "should be getting ready to implement his exit strategy." Kudlow then expressed reservations:
Mr. Bernanke has a poor track record here. As Alan Greenspan's copilot in the early 2000s, Bernanke deliberately dissed the dollar and commodities in Fed meetings as potential inflation influences. So from 2002 to 2005, an over-easy Fed bubbled up housing, energy, and commodities, allowed the dollar to sink, and wound up moving the consumer price inflation rate from 1 percent to 6 percent, all of which helped sink the economy into the Great Recession. [...] I have no doubt that Mr. Bernanke and the Fed have the right tools to protect the consumer dollar. The question is: Do they have the wisdom?
Also in July of 2009, Randall Forsyth in "Bernanke's Non-Exit Strategy" at Barron's wrote:
Bernanke, the entire Fed, the Obama Administration, every member of Congress and all Americans should jump for joy for the day when the monetary authorities have to tap the brakes. That's because housing, employment and output would be in an upward swing, an outcome devoutly wished by all.
But Bernanke knows the risk of braking too soon. That's what happened in 1937, which fiscal and monetary policies both tightened, in part of misplaced fear of inflation. That set the stage of the second leg of the Great Depression that followed growth from 1933 to 1936 that averaged over 9%, but still left unemployment well in double digits.
In exit strategies, the consensus seems to be that timing, if not everything, is crucial. In "Will Bernanke's Exit Strategy Work?" at Reason Foundation, Marius Gustavson in February 2010 wrote:
Unwinding its current monetary policy is a difficult maneuver: tighten too fast, and the Fed could risk setting off a much dreaded double-dip recession; tighten too slow, and high inflation could result.
At The New York Times, Sewell Chan ends a 2010 article headlined "Bernanke Hints at Timing of Exit Strategy" by quoting Laurence H. Meyer, a former Fed governor:
"The Fed is operating in uncharted waters," he warned. "It has never had such a challenging exit. Don't expect the Fed to be perfect. Nobody is perfect."
In March 2011 at the Ludwig von Mises Institute, Robert P. Murphy concluded his article "Three Flawed Fed Exit Options" thus: "Bernanke has effectively gone "all in" with his successive rounds of quantitative easing, and I get the queasy feeling that he's bluffing." In August 2012, Martin Hutchinson at Prudent Bear wrote:
Various policy reversal strategies would be counterproductive. To take the most extreme example, it would be foolish to attempt to reverse "QE" without doing anything about the deficit. That would double up on the strains to the financial market from financing the deficit, making the annual net cash flow drain on the market perhaps $2 trillion rather than $1 trillion. Almost certainly, this would cause a liquidity crunch, producing an economic lurch downward that would both worsen the deficit and bring even more misery to the American working class. [...] It thus follows that reversing QE must come late in the Bernanke reversal process; that lowering the deficit must take a top priority and that spending cuts should precede or at least coincide with tax cuts.
Also in August 2012, Nouriel Roubini (aka Dr. Doom) opined: "the crucial policy issue ahead is how to time and sequence the exit strategy." Roubini continued:
"If not reversed, this combination of very loose fiscal and monetary policy will lead to a fiscal crisis and runaway inflation, together with another dangerous asset and credit bubble. So the key issue for policy-makers is to decide when to mop up the excess liquidity and normalize policy rates. [...] The biggest policy risk is that the exit strategy from monetary and fiscal easing is somehow botched, because policy-makers are damned if they do and damned if they don't. [Italics added.]
So more than three years after the first calls for an exit strategy, and we still haven't taken that off-ramp. In fact, we've just embarked on QE3, which is open-ended -- it could go on forever. Congress has spent about a $1T in stimulus while the Fed has created a few trillions in QE, and yet, "No Exit" by Jean Paul Bernanke is still the only play in town and the only title on marquees.
More than four years since the financial crisis began, America's central bank is still in "crisis mode," printing money. Is this what recovery looks like?
Jon N. Hall is a programmer/analyst from Kansas City.
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