The stock market often swings wildly on insignificant news, but yesterday Wall Street appears finally to have taken some real news in stride, flatlining in response to one of the most delicately and judiciously worded speeches we’ve heard from Mr. Bernanke since he took office. The Fed chairman was addressing perhaps the most crucial economic topic of them all — namely, how the Fed plans to wean the financial system off easy credit in the wake of the most spectacular monetary blowout in U.S. history. Turns out, he does have a plan. And although we have rarely given Mr. Bernanke a passing grade for anything he has said or done, this time he gets an ‘A’ for handling a tough topic without roiling the markets even slightly. Given the choices available, the plan is probably the best we could have hoped for.
Very simply, the Fed intends to replace the federal-funds rate as its main policy tool, relying instead on adjustments in the interest the Fed pays to banks on excess reserves. Here’s how the Wall Street Journal explained it: “Raising the excess-reserves rate would give banks an incentive to park more funds at the Fed instead of lending them out to companies or households. In this way, the Fed would be able to restrain an economy that risks overheating and sparking inflation. Moving this rate would pull up other short-term rates, including the federal-funds rate, long the Fed’s main tool for steering the economy.”
Deflation Bonus
Excess reserves currently earn 0.25%, but in today’s deflationary environment, with nominal rates at historical lows, it’s not hard to imagine banks turning into hard-core “savers” if the incentive to park funds risklessly at the Fed were raised even a skoach. What’s more, the process makes tightening sound more like a reward than a punishment. Instead of raising interest rates to throttle credit, the Fed would be raising them indirectly by giving the banks a greater incentive not to lend. The very word “tightening” always scares hell out of investors, but yesterday’s subdued reaction to Mr. Bernanke’s speech suggests he has found a way to say what needs to be said without causing a stampede. Although we don’t expect the Fed to attempt tightening in any way, shape or form for the foreseeable future, it’s mildly comforting to know that there may be way to at least talk about it without bringing the whole house of cards tumbling down.
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Posted by Rick for Brian Benton:
One of your subscribers here … I had a different take than you on Bernanke and the Fed. Here are my comments, which I will probably wrap up into another Financial Sense article that follows the piece I did last July on the “Fed Exit Strategy”. http://financialsense.com/fsu/editorials/2009/0729a.html
I believe that most of the financial media do not have their eye on the ball. Monetary policy targeting the federal funds rate (and discount rate) is impotent now. Massive QE made sure of that. Any talk of hiking the target for federal funds is empty speak because it will not matter to the current state of the banking system.
The Fed is powerless to affect the fed funds rate by conventional monetary policy. Banks do not need reserves. They are flush with them.
The discount rate does not matter either at this juncture. Banks do not need reserves. They are flush with them. Besides, nobody is using the discount window now. The Primary credit facility has a balance of less than $15 billion.
Bernanke knows that monetary policy targeting interest rates at this time is impotent. But by speaking out about how the Fed is going to get tough with interest rates, he can fool most into thinking that the Fed is really tackling the tough problems and is executing a real exit strategy. But he is not. He is buying time to stretch out these problems as long as he can … and so he can figure out the best option spread out over the longest time period possible.
Monetary policy targeting the federal funds and discount rates can only be effective again once the Fed gets its balance sheet back to near pre-crisis levels and interest on reserves is rescinded. All of these supposed “tools” for exit (these are not new) are simply delay tactics. They lock bank reserves into place (sterilize them) (interest on reserves, term deposits) or temporarily drain the balance sheet (reverse repos) only to re-fill the balance sheet once the reverse repos mature (< 1 month). As for the interest rate paid on excess reserves, this obviates the federal funds rate while it is in place. But it still suffers from the same problems I describe above. And it is not an exit strategy because it does not drain reserves (drain the Fed balance sheet). It only serves to discourage bank lending/investment (lock them up or sterilize them) ... which is not a problem right now because the Fed is only paying 0.25% interest on reserves and the banking system still has over $1 trillion in excess reserves. If the banks are not lending these reserves now, why would the Fed pay them even more (increase in interest on reserves) to still not lend these reserves? The Fed has never been known to be proactive ... just reactive. When the banks do begin lending/investing these reserves, then you will see the Fed move ... and then the banks will reassess what to do (lend/invest or hold reserves and get free interest). The federal funds rate and discount rate are not important now. Increasing the interest paid on excess reserves does not drain reserves. It is a stall tactic, not an exit strategy. The real operations of the Fed, the size of the balance sheet, and excess reserve levels are what is important. That will tell you what is really going on. Until the Fed begins a real move to sell a sizeable chunk of the assets on its balance sheet (needs to sell about $1 trillion for a complete exit from this point), everything else is just a distraction (smoke and mirrors). This is when the rubber is going to meet the road. Regards, Brian