Bernanke’s Plan To Drain The Monetary Swamp
Interest rates are at record lows and literally trillions of hastily printed dollars have been pumped into the economy by the Federal Reserve in an effort to stem an even deeper recession. While it is debatable as to whether or not it has really accomplished that goal, what isn’t debatable is at some point, the Fed has to wring that excess money from the economy or risk all sorts of dire consequences.
The Wall Street Journal carries the Bernanke plan for doing so. The centerpiece of that plan is found in the interest rate the Fed pays banks on the reserves it keeps. Right now, that’s .25%. The plan is to gradually raise that rate with the assumption that such rate raises will give an incentive to banks to keep even more money on reserve and thus out of circulation. This “interest on excess reserves” then is the primary vehicle the Fed plans to use to begin to pull money out of circulation.
But that’s a process fraught with risk. Because the immediate effect of any such interest rate increase will be to tighten credit. And depending on the strength of the economy, it has the potential to affect it negatively. Says the WSJ:
Extricating itself from these actions [low interest rates and trillions of infused dollars] will require both skill and luck: If the Fed moves too fast, it could provoke a new economic downturn; if it waits too long, it could unleash inflation, and if it moves clumsily it could unsettle markets in ways that disrupt the nascent economic recovery.
It’s pretty easy to drop interest rates and pump money into a down economy. But going the other way is not at all as easy. “Skill and luck” are understatements. Timing will have to almost be perfect. The problem is, should markets get skittish because of moves by the Fed that it sees as having a negative effect, things could break negatively quickly and spiral out of control. While the Fed would like everyone to believe this is a piece of cake – and will continue to tell us it is – it’s not at all an easy thing to do. The desire of those talking positive about the ease of draining the monetary swamp is to bolster confidence and allay fears if possible so a panic which could undermine the whole plan doesn’t develop. That, however, is going to be extremely difficult:
The nature of its exit from today’s unusually low interest rates will affect everything from mortgage rates and what companies pay on short-term borrowings to the rates savers earn. The timing and sequence of the steps are the subject of intense speculation in financial markets.
At the risk of boring the living hell out of you, I want to stress that this plan may be one of the most important plans in quite some time. If it isn’t executed perfectly, we could see a quick slide back into recession or rampant inflation. Read the whole article if you get a chance. The Fed has some other contingencies and plans as well. But as you’ll see as you read through them, all present the possibility of having a very negative downside if the strength of the economy is misread and/or the execution of each portion of the plan isn’t almost perfect.
The economic high-wire act – without a net – the Fed is about to embark upon is a very difficult one. Yes, it’s necessary and, in fact, critical – but it isn’t going to be easy. And if screwed up, could be pretty devastating to a recovering economy.