How the Fed plans to exit the bailout fray

A widely read opinion piece written by the Federal Reserve’s Chairman, Ben Bernanke, appeared in the Wall Street Journal yesterday. The piece was entitled, “The Fed’s Exit Strategy.” A summary of the piece follows along with my commentary.

• Right now many banks are keeping reserve balances at the Federal Reserve itself. The amount of those reserves is approximately $800 billion (!) and much higher than normal. As the economy recovers and banks start making more loans to consumers and businesses they will draw down those reserve balances. That will inject a lot of money into the economy. In turn, that will create a big inflationary pressure.

To countermand that inflationary pressure the Fed plans to: 1) pay interest to banks holding reserve balances at the Fed, 2) arranging reverse REPOs of reserves, 3) the US Treasury sells T-bills, 4) the Fed could offer Certificate of Deposit-like accounts to banks, and 5) the Fed could sell reserves in the open market. Let’s take these in turn.

1) Wouldn’t paying interest on the reserves directly to banks actually put more money into bank hands? Wouldn’t that increase the amount of money that banks can lend and in turn, put money into the economy and create inflation pressures? Bernanke says no. The reason he provides is that if the Fed pay a higher interest rate on reserves held at the Fed than banks can earn by lending money in the money market, then banks will continue to hold their reserves at the Fed. That means that they will not loan out the reserves.

Of the possible measures at the Fed’s disposal this is by far the most powerful. It gives the Fed a solid grip on when bank reserves start to enter the economy. This is because most rational bank executives are not going to engage in non-economic behavior. If they can earn more money at the Fed then they do so. In addition to the Fed paying a higher interest rate there is virtually no fear about getting the principal of your investment back from the Fed, alias God Bank. This contrasts with the credit fears banks have when they invest their principal with a mere mortal bank.

2) What the heck is a reverse REPO? REPO is short for “repurchase obligation.” In the Fed’s case it would sell securities that it owns to banks and government sponsored institutions such as Freddie Mac and Fannie Mae. The Fed then promises to buy these securities back at a later date for a slightly higher price. When the banks purchase these securities they have to pay for them – that takes money/liquidity out of the economy and keeps inflation pressures down.

The success of this program would be highly dependent on whether or not banks have higher return potential in other investments. Hopefully at some point banks will start lending money again – and even more hopefully they will lend money MORE prudently than before.

3) The U.S. Treasury sells Treasury Bills (short-term bonds) to the public and deposits the proceeds from the sale with the Federal Reserve. As the T-bills are paid for by investors those monies are given to the Federal Reserve. Again, this drains money out of the economy and gives the Fed the ability to lower reserves (introduce money into the economy) at a rate slower than money is taken out (by buying T-bills).

The measures all make use of getting the public to trade liquidity/money for a less liquid investment security. Again, the success of this plan depends on the attractiveness of competing investment opportunities for the banks.

One fear associated with option 3 is that the Fed was set up as an independent operator from the Federal government. Using option 3 directly associates the Federal Reserve with the U.S. Treasury. So there is some fear of a loss of independence for the Fed in this scenario. I happen to think any fears of this are overblown. I would trade a diminished Fed independence in the short-run for a healthy economic recovery in the long-run.

4) The Fed could offer higher interest rates to banks on their reserve deposits if banks agree to keep the reserves with the Fed for a longer period of time. This is identical to the CDs that banks offer consumers.

This is a clever idea, especially if, in the terms of the CD, the Fed is able to get excellent flexibility in terms of the timing of when it has to pay back principal. Again, the overarching concern is whether or not a Fed CD is more attractive to a bank than a consumer mortgage or a big fat commercial building loan.

5) The Fed could sell some of the securities it itself owns. In other words, the Fed holds some sexy investments. It could offer these securities to the public. When those securities are bought it drains monies out of the economy, thus reducing liquidity.

Of the options listed by Bernanke this is the least attractive. Why? Because we all want a Federal Reserve that has a balance sheet chock full of strong investments. Selling high quality assets to drain liquidity out of a public banking sector that can’t wipe its own butt is not an attractive option to me.

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In general, I believe that Bernanke has proved to the public that the Fed has many measures within its power to ensure that inflation does not soar once the economic recovery is underway. He stated yesterday that the Fed feels a full economic recovery is still several years into the future so inflation is among the least of his worries.

Jason