Wednesday, July 22, 2009

Bernanke Continued......

Ben Bernanke told the market just what it wanted to hear on Tuesday when he promised the central bank has the will and the tools to guide the economy out of recession without spurring inflation. Really? How is that going to happen?

But even as equities cheered his words, which triggered a bond market rally, investors still harbor doubts that Bernanke can quickly drain the trillions of dollars pumped into the economy during the crisis once a recovery finally takes hold.

Where Is The Exit Strategy?

There is none at the moment as it will be incredibly difficult for the Fed to agree when an exit strategy is necessary. Try getting all the Fed members to agree at what point the economy is finally on a sustainable path to recovery. This is going to be very difficult.

Bernanke is implying that the Fed will keep interest rates at zero for some time yet and continue to inject money into the economy through purchases of government and mortgage debt. These unorthodox policies have ballooned the Fed's balance sheet and left the United States looking at a record $1.8 trillion deficit for the current fiscal year.

Whats The Verdict - Inflation Or Deflation?

Bernanke's confidence likely stems from his belief that inflation is not a threat, at least for the next year or two. That there is excess capacity to soak up liquidity once a recovery takes hold.

The Debate Is:

Are we facing a deflationary threat or an inflationary threat?

Implied in all this is that inflation is a bigger threat, but that's not a given.

Indeed, signs that current policies are no longer needed, easier bank lending standards, increased credit creation, higher consumer spending, a narrowing gap between the economy's current output and its full potential, are all still absent and far from resolving each other.

When recovery does start to gain traction, Bernanke said the Fed has a number of tools, beyond raising benchmark rates, that it can use to drain money from the system, such as paying interest on Fed deposits and selling some of its long-term securities.

But that's when things can get dicey, and investors and economists fear the potential for policy mistakes are large.

To me they have no experience coming out of a great recession like this, so to argue they know exactly what to do is of great concern. They simply have too much on their plate.

From watching the Fed the last few years, my confidence in the Fed has been greatly shaken. They were behind the curve for a long time, now they are ahead of the curve on printing money. Now they want more power and greater flexibility to handle system risk?

What are The Pitfalls?

The first issue is timing, when does inflation become enough of a concern and U.S. growth look sustainable enough to warrant the start of the Fed's exit strategy? Because there is no clear model or indicator on what tools to exit with, that is where the fuzziness starts. The problem here is if you don't time it right, either you dip the economy back into recession, or you will fuel inflation.

Typically, central banks drain money from the system by raising benchmark interest rates and selling securities, but the scope of this particular crisis makes the latter difficult. Active sales of securities bring even bigger problems.

I am thinking once the Fed completes its asset purchase plans, they will hold $1.25 trillion in Treasury, agency and private mortgage-backed debt. Letting maturing bonds run off would take a long time to shrink the Fed's balance sheet as it will only cut Treasury holdings by just $77 billion in 2010.

They can't dump huge amounts of paper onto the the market without having some seriously detrimental implications for long-term rates.

An even a worst case scenario could include foreigners fleeing from the USD and Treasuries, driving yields even higher and stopping a recovery in its tracks.

Other Options Also Have Difficulties.

Reverse repurchase agreements, in which the Fed sells securities with an agreement to buy them back later at a higher price, would help drain cash from the system.

Also impaired balance sheets at the primary dealers with whom the Fed usually transacts such agreements mean the dealers may not be able to hold up their end if this tool is used on a large scale.

Dealing directly with money market funds instead would risk triggering a financing crisis for the dealers, as a money fund that has the choice of dealing directly with the Fed or a dealer, would likely choose the Fed instead.

Another Problem

Interest payments on money banks hold at the Fed would also help but could be a political time bomb.

There will eventually be a situation where the Fed is paying the banking system something like 5.0% on $700 billion of reserves. This would mean the Fed would be paying the banking system $35 billion per year of what is ultimately U.S. Taxpayer money in order to push up interest rates.

The Fed is still likely a year or more away from even implementing an exit strategy. So there is time.

This is the primary uncertainty that will be with us for years.

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