Duh.

Duh.  I don’t like saying “Duh.”  There’s something dumb-sounding about it.  The only thing worse is saying “Duuuuh,” or “Duuuuuuhh.”

Yet, when I read Dr. Bernanke’s Op-Ed in the Wall Street Journal today, my initial response was “Duh, of course, in order to exit all ya gots to do is do the opposite of what ya did to enter.  It will be cheap and simple.”

Why should the Fed think that doing the opposite will be easy?  Take the Fed’s forelorn policy tool, the Fed funds rate.  When has it been easy to raise the rate?  Only very bold central bankers would act before it was clearly needed.

Wait, Give Dr. Bernanke a chance.  What did he say?

First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline.

The Treasury has been conducting such operations since last fall under its Supplementary Financing Program. Although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.

Third, using the authority Congress gave us to pay interest on banks’ balances at the Fed, we can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.

Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

What is his first method?  Suck cash out of the system temporarily, and hold fixed-income assets while waiting.

The second method is to let the Treasury suck cash out of the system temporarily, perhaps compromising Fed independence somewhat.

Third?  Make a good offer to the banks so that they lend to the Fed and not to customers, slightly longer-term.

Finally, the Fed could suck in cash by selling the Treasury, Agency, and Mortgage bonds they have acquired, perhaps raising longer-term interest rates in the process.

It all sounds easy.  But tightening the Fed funds rate is not easy, particularly toward the end of the cycle.  What of these new policy tools?  Will they face similar difficulties?

Yes, and maybe more.  The Fed lacks experience with these tools.  As I have said before, policy accommodation is like a drug: easy to receive and hard to withdraw.

As the withdrawal occurs, there will be pain, and more so as the withdrawal continues.  Can you imagine what happens to the bond markets when they realize the Fed is selling?  It will be ugly.  Welcome to the asymmetry of the markets, Dr. Bernanke.

One thing that was neglected were all of the specialized lending programs.  How do they get unwound?  I’m not sure, but I believe the same pain thresholds apply, only that special interests will complain privately.

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Making the markets happy is a fool’s bargain, Dr. Bernanke.  Doing that leads into a liquidity trap, as your acquaintance Dr. Greenspan left you with.  The markets need to be jolted every now and then to know that you aren’t their slave.  Without that, the markets grow complacent, realizing that the Fed exists for their aid and comfort.

In the short-run, Dr. Bernanke, it is always easier to please that fickle mistress, the markets.  Dr. Greenspan learned that all too well.  The markets will eat until they are obese — even beyond that, until they are regurgitating breakfast.  In a macroeconomic sense the markets are not efficient — they will take whatever the government gives, and beg for more, until it kills them, like a drug overdose.

In that sense, the long term is not the sum of short terms.  Rather the seemingly optimal short terms can lead away from what would be optimal long term.

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With that, I end this piece.  On the off-chance that you are reading this, Dr. Bernanke, Ben, I would simply say that removing policy accommodation is easier said than done.  There are always tensions, regardless of the method, and political and economic pain to boot.  Embrace the pain, and let elected officials deal with the consequences.  You’re a brave man, but it is their responsibility — let Congress deal with the crisis.

3 Comments

  • But What do I Know? says:

    Great points, David–one can only hope that Uncle Ben is reading you, though somehow I doubt it. Too much straight talk for his liking, I should imagine. I have yet to grasp why this testimony was meaningful–surely anyone with two brains cells to rub together knew what the Fed could theoretically do, the question is what, and when, and who has the balls to do it. (Then again, he was testifying before Congress, so maybe he did need to outline it.)

    I didn’t see anyone else raise the point about option no.4–just who would the Fed sell to. Maybe Ben hasn’t figured out that he’s the Last Buyer yet, but everyone else has. He’s stuck to that Tar Baby. He can’t sell long-term assets when things are going badly (because that would raise rates) and he can’t sell them when things are going well because then no one will want them.

    Your discussion about the fortitude required of central bankers is germane and really is at the root of the problem. We were much better off when people hated the Fed chairman than when they agreed with him.

  • But What do I Know? says:

    One more thing–the more the Fed talks about eventually selling those MBS’s makes it all the harder for them to keep rates low by buying them up. After all, if you want to unload the MBS, wouldn’t you want to sell now, when you have a willing buyer, rather than later, when you’ll have competition?

  • Jeff says:

    David – Why are you so confident that Bernanke, who has responsibility regarding employment and price stability, is targeting markets?

    Do you have any evidence for this viewpoint? The record of Fed transcripts has been pretty clear. They are interested in markets only as a vehicle for economic effects. Their focus is on the economy.

    Put another way, let us suppose that you had been the Fed Chair over the last few years. What do you think would be the current state of the economy, unemployment, credit markets, etc.?

    It would be an interesting article, and a bit more challenging that what you have written here.

    Please compare with http://oldprof.typepad.com/a_dash_of_insight/2009/07/politics-ideology-and-investing.html

    Thanks for the stimulating post!
    Jeff