Bernanke's Conundrum

The 1960’s cartoon character, Snagglepuss, lives in a cavern which he is constantly attempting to make more livable. Despite his best efforts, poor Snagglepuss is always left worse off than when he started to which he exclaims “Heavens to Murgatroyd!”

In a Snagglepuss type move, Ben Bernanke wrote an opinion piece, published by the WSJ, outlining the Fed’s exit strategy. While we applaud the Chairman’s attempt at transparency we fear the publicity hungry politicians will use the Chairman’s words to make his life less comfortable.

Nonetheless, he does lay out in very basic form the Fed’s exit strategy. The three pillars of the exit strategy are:

1.Let the instruments purchased by the Fed expire.
2.Raise rates on reserve balances
3.Sell outright securities on the balance sheet

Point number one is something that we have written about in the past. The Fed’s quantitative easing program has focused on buying securities that mature in 2012 and 2013. Since the Fed expects accommodative policy for an extended period it stands to reason that the Fed expects this period to last at least another few years. However, if circumstances change the Fed is ready.

Monday on CNBC, we spoke about the increase in M1 multiplier and how that may lead to further increases in M1 or M2. The Chairman must have watched our 90 seconds of fame because in his editorial he suggested that as banks find more opportunities to lend out the monetary base a faster increase in M1 or M2 could occur. The Chairman cautions that a rapid increase could lead to inflationary pressures.

Like us, the Chairman is concerned about the massive amounts of excess reserves held at the Federal Reserve. According to the Chairman, as that money seeks better investment opportunities inflation could ensue.

Click to enlarge:

We published the above chart in Monday’s Surf Report when we suggested that the destination of the falling excess reserves has been and will be the US equity market. Chairman Bernanke takes our analysis one step further as he is concerned about that money reaching the “real” economy.

His plan to combat a massive rush of money into the real economy is to increase the interest rate paid on reserves. In this way, banks will only have incentive to loan money into the real economy if the return is greater than the risk free rate earned on reserves.

This assumes that the economy will recover enough to produce higher yielding risk adjusted investment opportunities. Our concern is a seriously crippled financial system no longer has the ability to produce above normal risk adjusted returns.

The danger is that in an effort to fight perceived inflation the Federal Reserve chokes off the economy at the exact time it needs oxygen. And, much like Snagglepuss, we end up worse off than when we started. To which we exclaim…”Heavens to Murgatroyd!”

Comments

[conceptwizard:]

Good Post! Ben Bernanke is making a real attempt to do the honorable thing. This is not the first time that he has had "truthful" moments. In front of Congress he warned them of cutting back entitlement program costs or he would be not be able to roll debt. It is encouraging to see the most powerful man on the planet have more integrity than PR President.

What I take from this is a warning that their are major issues he has to deal with that are in no way bulletproof to work, we are still at the whim of many factors. The markets have not "priced this in". This is a very unstable time and will remain so for the forseeable future. Excercise extreme caution.

Jul 22 08:53 AM

[CautiousInv...:]

The question of exit strategy has less to do with the mechanics of the Fed balance sheet and more to do with the will to take the nescessary action to fight inflation should unemployment remain high amidst political opposition to higher rates.

Jul 22 09:48 AM

[Moon Kil Woong:]

Good point as always Cautious Investor. Similar to all their other talk and no action I expect the same this time. Getting the Fed out of the market and away from an easy money liquidity stance is near impossible save in the face of raging inflation, and even then they might not do it (look at Carter's term). It took Greenspan forever to get away from easy money (he never did it).

Good luck finding another guy like Volker to pull the trigger. The new Fed hopeful Larry Summers certainly doesn't look the part to inflict short term pain and career hari kari in for the good of the country.

Jul 22 11:22 AM

[Boxed Merlot:]

“His plan to combat a massive rush of money into the real economy is to increase the interest rate paid on reserves. In this way, banks will only have incentive to loan money into the real economy if the return is greater than the risk free rate earned on reserves.”

Are these interest bearing “reserves” Federal Reserve Notes these same banks “borrowed” from the Fed at “0 - .25%” to start with or do they have to repay all those before they’re paid interest on the excess balance, i.e. what theyre able to scrape up out of the market at large? And is the interest the Fed pays out on these reserves fiat currency as well? I apologize for the elemental questions but y’all have been very gracious in the past with helping to untangle this stuff and I appreciate your patience.

Jul 22 01:07 PM

[WhoisJohnGalt:]

Get your umbrellas, Helicoptor Ben is gonna make it rain.

Jul 22 02:36 PM

[Barbarous R...:]

It will be very interesting to watch how Bernanke balances the conflicting goals of "full employment" with "price stability" in an environment where both are likely to be going in the wrong direction.

And how he balances these goals with the personal goal of establishing his legacy as a central banker.

Jul 22 03:33 PM

[whidbey:]

Why worry?

His discussions are all hypothetical anyway. He knows that he dare not reduce the liquidity because the banks are in poor shape and they will want to neither lend or buy bonds. Yes, it is Hobson's choice and we know how that works, except this time there are no options, just talk.

Jul 22 04:16 PM

[DannyBoy29:]

My big fear is all the government involvement. I can see a situation where congress, most of whom know nothing about economics, attempts to force rates up to early or conversely tries to keep them low too long for their own political reasons.
Ben has done a good job in my opinion since September 08 and I hope political pressure will not influence him.

Jul 22 05:08 PM

[msgtb:]

Bernake has been 100% wrong during this crisis which the Federal Reserve helped case. Remember him saying this will be limited to only sub-prime mortgages?

He has been and continues to be wrong our only hope is the Chinese and Japanese holders of US Treasury Bonds.

Truly we need to audit the Federal Reserve and then abolish it.

Good luck and good trading

Dave

Jul 22 08:07 PM

[derryl:]

Boxed Merlot,
It's all fiat money. All US monetary instruments ultimately can only be converted into Federal Reserve Notes, or "cash". The cash is supposedly a 'liability' of the Federal Reserve Bank, but if you try to redeem their notes all they can give you is more of the same notes. They have no other tangible assets backing up their paper. Federal Reserve Notes are the end of the line.

Commercial banks only hold about 4% of their customers' short term (e.g. checking account) deposits in cash. The percentage is not legislated; it is just the amount banks have found they need to keep on hand to satisfy customers' cash withdrawals. If you read the fine print you will see that banks can require notice of large cash withdrawals from savings account or other long term deposits: they may not have enough cash on hand. Banks earn no interest on their cash holdings so they try to keep it to a minimum. The banks have to buy this money from the Fed, paying with bonds or warrants or some other form of IOU.

The excess reserves the banks have at the Fed are electronic, not cash. Some of that money came from TARP and other programs that pumped money into banks to shore up their balance sheets against asset losses and writedowns. If the banks are paying interest on the money they are holding on deposit at the Fed then they may be breaking even or losing a bit on the interest spread. But getting a little bit of interest from the Fed is better than getting nothing just sitting on your lendable money ("excess" reserves means money the banks have beyond their legislated reserve holdings, and normally banks try to keep that money lent out and earning interest but right now there are insufficient viable borrowers and the banks may end up needing those reserves against losses that have not yet been brought forward onto their balance sheets).

Money is a simple but confusing thing, isn't it?

Jul 22 10:56 PM

[Up Yours SP500:]

"The Chairman must have watched our 90 seconds of fame because in his editorial he suggested that as banks find more opportunities to lend out the monetary base a faster increase in M1 or M2 could occur."

---I find it amusing you seem to think you were the one's that influenced the Fed with your 90 seconds of fame....if the Fed did not already see this coming, I would be extremely worried right now. 138 followers will believe you, several million won't. Nice try.

Jul 22 11:19 PM

[Henry Buttal:]

While the Chairman's concerns about inflation reflect what is ultimately inevitable, that doesn't make it immediate.
I think Chairman Ben is also concerned about what the current Administration is ignoring - the Fed could run out of tools to fine tune the money supply at the same time the process of U.S. debt rollover becomes more expensive and challenging, leading to a nasty combination of local inflation and global dollar devaluation.

It is an ugly possiblity that would result in the historic changes in the U.S., and not necessarily in a good way.

Jul 22 11:41 PM

[Boxed Merlot:]

On Jul 22 10:56 PM derryl wrote:

> Boxed Merlot,
> It's all fiat money...
> Money is a simple but confusing thing, isn't it?..

Thanks for the lesson. What interferes with much of my understanding is that I was exposed to a couple of Peter Schiff's father's books early on:

The Kingdom of Moltz (1980) ISBN 0-930374-02-9
and
How an Economy Grows and Why It Doesn't (1985) ISBN 0-930374-06-1

It's been difficult to re-indoctrinate myself after such simple instruction, but I'm working on it.

Jul 23 01:23 AM

[Leif Peterson:]

No matter what type of monetary easing hits the streets, it will be tantamount to a "last breath" in which short-term euphoria sets in, and then the lights grow dim. The next bubble is the dollar, so during its decline the there will be a sharp bull-run of the equity markets. Groups with a lot of Yen, Euros, Australian dollars will likely jump on equity purchases of strong depression-proof US corporations (whose earnings have increased through Q4'08, and Q1,Q2'09).

This may be the ride of a lifetime, so the trick will be knowing when to get off at the train station (out of the equity markets). AT that point, you may need to transition much more heavily into e.g. gold or PMs, or another currency.

Jul 23 10:24 AM

[stojan nena...:]

The Federal Reserve is not necessary. Congress must create new money as gift. This is a non-credt money. Non-credit money is the necessary additional quantity of money in circulation (dM) as percentage (k) of existing quantity of money in circulation (M).
dM = kM ; k = (supply - demand)/demand ; If non-credit money is emitted according to the cited formula, inflation cannot exist. Also, taxes are annulled for the amount of non-credit money. The consumers pay less and producers get more than today, in the order of credit money. Instead of economic crisis, we get new world order of non-credit money. Without inflation, without deflation, without economic crisis, without debt and without the Federal Reserve.

Jul 23 11:28 AM

[joebhed:]

Out of the 550 representatives of the people of the United States of America, the actual OWNERS of the US Money System - the ONLY ones who are resonsible for aying all these $Trillions in dollar-denominated debts, perhaps a half-dozen really understand what Bernanke is saying here.
Which, to my mind, if they do, they have now discovered the "exit-strategy" strategy.
It is our strategy to have an exit strategy so that we can later talk about how and when to implement the strategy, if we only had one.
It's like that old Lenny Bruce skit about the boy going down the bad road.
Actually, Ben, a strategy is something that you select from a number of options available to you to ACHIEVE THE GOALS of the strategy.

The previous best example of the strategy-less strategy was the monetary easing that happened when the Fed punched a bunch of new holes in the money-system walls and opened new windows for business. Unlike in Japan where the monetary authority laid out its goals(unachievable, as it turned out), and "quantified" the needed commitment, we just sashayed out the imminent and exigent circumstances clause for the Fed to do anything it wants, and out came the $$Trillions.

So, Mr. Chairman, if you don't mind, rather than telling us all the tools in that handy little magical toolbox at the Fed that can result in an interest rate increase, why not tell us how the selected strategy will impact things like, you know, full-employment and price stability.

That could actually be an indication that the strategy could accomplish something.
So, Doctor Ben, what is the strategy?

Jul 23 01:47 PM

[joebhed:]

OOOPS.
that shoulda been 535 .


On Jul 23 01:47 PM joebhed wrote:

> Out of the 550 representatives of the people of the United States

Jul 23 01:49 PM