Free Markets, Free People


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.

~McQ


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14 Responses to Bernanke’s Plan To Drain The Monetary Swamp

  • Why were they paying interest of 0.25% in the first place when they wanted banks to lend more?
    I would say that I think its probably easier to reign in inflation than it is to deal with deflation.
     

  • There are better odds of you winning the lotto 3 times today, than there is of the Fed being able to “pull money out of circulation.”

  • It’s rather scary to think that getting out of this situation relys upon the acumen of:

    — Ben Bernanke, who engineered it in the first place after being asleep at the switch when the economy started going to hell in ’07;

    — Barack Obama, whose sole skills seem to be blaming Bush for everything bad that happens to our economy and spending wasting huge chunks of borrowed money;

    — The Congress, whose sole interest in ANY situation is, “How can we get votes and / or make money off this?”

    No, I take that back:

    It’s VERY scary to think that this bunch of clowns are in charge.

    The timing and sequence of the steps are the subject of intense speculation in financial markets.

    Yeah, I’ll just bet that they are.  In effect, Bernanke is willing to bet our economy on his ability to judge the market with god-like shrewdness.  You know: the market that changes from minute to minute not only based on the performance of the thousands of companies who trade stocks, not only on news reports of items ranging from unemployment figures to earthquakes to sports scores, but even on how the traders and managers and executives feel on a given day.

    This can’t end well.

  • Meanwhile, Wall Street is getting tired of playing “kick the ‘fat cat’”

    “The expectation in Washington is that ‘We can kick you around, and you are still going to give us money,’ ” said a top official at a major Wall Street firm, speaking on the condition of anonymity for fear of alienating the White House. “We are not going to play that game anymore.”

  • Can you say, “Carry trade wipe out?”  One of the things TBTF has been doing is running a carry trade with the US dollar.  Basically, what they do is get near zero interest loans from the Fed and buy foreign debt instruments that pay a higher rate of return.  They then pocket the difference.  This all counts on the dollar being weak and the interest rates staying low.  If either does not then they take a bath.  Raising interest rates would have the effect of strengthening the dollar.  At which point TBTF needs another round of bailouts.
    But wait!  There is more.  Keep an eye on what is going on in Europe with the sovereign debt problem.  If that blows up then there will almost certainly be a flight to US dollars as a safe haven.  If such is the case then TBTF takes a bath again.
    And for the hat trick, higher interest rates would make for a stronger dollar and possibly a flight from equities.  If such is the case then the stock markets take a plunge.
    But the Fed can’t keep up with the easy money policy lest they inflate a bubble and have it burst or run up inflation.
    It is a catch-22.  The economy is screwed no matter what they do.

  • This presumes that a second, or double-dip, recession is avoidable at this point regardless of what is done.  I really don’t think it is.
    And Bernanke does get a bit of a bum rap, for while he did nothing to alleviate the approaching meltdown, the course was set long before he took the post.  Interest rates have been far too low, for far too long, they have to come back up.

  • Bruce’s post about deficit spending brings up a few more aspects for the Fed.
    Higher interest rates will drive up the cost of deficit spending.  With less credit out there due to less liquidity at the banks, the US government on its borrowing binge crowds out the market.
    I can only imagine the intense political pressure being applied to the Fed to not raise interest rates while the politicians in Washington are running trillion dollar deficits.

     

  • The reason we are in this mess to start with is that credit was way too easy to get. A little tightening ain’t a bad thing.

    If Bernanke wants to increase bank reserves, why doesn’t he just increase the reserve requirements? Plus, I thought the problem now was that banks were sitting on their assets instead of putting them in circulation.

  • It is not going to work, well, that is my vote, it will fail.  Whether it fails up or down, (inflation or deflation) I can’t tell, but I am tending toward inflation.
    Remember that the 1970′s proved that you could have low and even negative growth along with high inflation. It is possible.

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