You may recall from my prior missives (Fed Exit Strategy? and Fed Exit Strategy? (An Update)) that the Fed was signaling delay tactics as its approach to the management of its unprecedented balance sheet, as opposed to a real exit which would require returning the balance sheet to mostly pre-crisis levels (permanently draining the massive bank reserves it created) and once again conducting monetary policy via management of the federal funds rate (via its traditional temporary open market operations). In today's speech to the National Press Club, Bernanke made it even more clear that the primary strategy is to employ policies and tools that will "lock up" or "immobilize" excess bank reserves. A real exit where the Fed contracts its balance sheet by selling securities is mentioned as a secondary strategy.
Some quotes from Bernanke today and my comments in context ...
Bernanke:
"My colleagues and I have said that we will review the asset purchase program regularly in light of incoming information and will adjust it as needed to promote maximum employment and stable prices. In particular, it bears emphasizing that we have the necessary tools to smoothly and effectively exit from the asset purchase program at the appropriate time. In particular, our ability to pay interest on reserve balances held at the Federal Reserve Banks will allow us to put upward pressure on short-term market interest rates and thus to tighten monetary policy when required, even if bank reserves remain high."
Yet you still have the mainstream financial press discussing the federal funds rate as if it has any significance in this monetary environment. Wake up call folks ... any tightening by the Fed is well into the future ... and when it happens, the federal funds rate will only move higher in response to a Fed increase in the interest rate it pays on reserves. The interest rate paid on reserves serves as a floor to the federal funds rate, sans some federal funds market transactions that take place where non-depository institutions are willing to accept less than this rate in the lending of their reserves as they do not qualify for this Fed perk.The supply of reserves massively outstripping demand results in the interest rate paid on reserves also being the ceiling. Thus, the federal funds rate is impotent in this monetary environment and is just along for the ride.It will be the interest rate paid by the Fed on reserves that the Fed will adjust higher (at some time in the future), allowing bank reserves to not only remain at unprecedented levels ... but to increase (moving us farther away from a real exit) as the Fed funnels even more interest payments to the banks. The only way that the Fed can return to traditional monetary policy in a timely manner is by executing a massive sale of assets on its balance sheet (allowing these purchased assets to simply mature/expire is not timely). Thus, in order for monetary policy to be conducted through its management of the federal funds rate once again, on the order of hundreds of billions $ in excess reserves must be drained from the banking system in the short to intermediate term. For such policy to be usable on a long term basis, approximately $1 trillion would need to be permanently drained. Do not hold your breath.
Bernanke:
"Moreover, we have developed additional tools that will allow us to drain or immobilize bank reserves as required to facilitate the smooth withdrawal of policy accommodation when conditions warrant."
Here, Bernanke refers to other tools such as the Term Deposit Facility, which is a program to immobilize reserves for a more predictable period of time ... in contrast to the Fed program to pay interest on reserves (banks can decide to make use of these excess reserves at any time). These are stall tactics being implemented in an attempt to nurse the banking system back to health, while attempting to prevent the majority of these reserves (base money) from leaking into the money supply (via bank lending and securities investment) and creating substantial inflation (both monetary and price). Note that Bernanke does not say "permanently drain". A real exit requires excess reserves to be permanently drained. He uses the term "drain" because the tools to which he refers are reverse repurchase agreements, the Treasury Supplemental Financing Program, and other similar tools which will only temporarily drain reserves. These reserves re-enter the banking system once the agreements mature.
For the sake of completeness, as I have written on several occasions, even a real exit by the Fed contracting its balance sheet may not (will likely not) prove to be a full exit. At this point in time, the Fed does not have the ability to drain all of the excess reserves it created when it purchased the assets, as in aggregate the assets on its balance sheet have fallen in value. This situation is more likely to get worse than better as there will likely be more pressure on interest rates going forward, not to mention the prices of these assets if the Fed were to execute such a liquidation. The result would be some amount of excess reserves remaining in the banking system after liquidation, with the Fed functionally no longer able to sell assets to absorb those reserves. Another reason why the Fed payment of interest on reserves may be here to stay.
Bernanke:
"If needed, we could also tighten policy by redeeming or selling securities."
What is the only real exit strategy is practically mentioned in passing and in the last sentence of the portion of the speech addressing monetary policy. "If needed"??? This tells you all you need to know about the future of monetary policy. There is a new normal. That new normal is massive levels of excess reserves due to a super-sized Fed balance sheet coupled with a myriad of programs attempting to keep most of these reserves on deposit with the Fed, aiding in the slow but steady recapitalization of the banking system. We are already experiencing the predictable side effects of such policy, as evidenced by asset bubbles and commodity inflation. The macro result will be continued volatility in the financial markets, asset bubbles, inflation, and many misreadings of the economy by entrepreneurs and businesses deciding whether or not to make capital investments.
