How Will the Fed Defuse the Monetary Time Bomb it has Created
DECEMBER 03, 2009 by STEVEN HORWITZ
Filed Under : Federal Reserve, Government Spending
Among the terms introduced into our collective vocabulary this decade, “exit strategy” is particularly notable It’s been around awhile but lately politicians have used it much more frequently. The older political use is associated with the wars in Iraq and Afghanistan. The debates in Congress and at the Pentagon over how to extract ourselves from these imperial adventures has focused on designing the right “exit strategy.”
More recently, though, the Federal Reserve has used the same term to describe the problem it currently faces because it massively expanded the monetary base over the last year. In response to the financial crisis in the fall of 2008, the Fed tried to avoid a scramble for cash that could have rippled through the banking system in ways similar to the early years of the Great Depression. There is much debate over exactly what it should or should not have done, but even if one thinks some expansionary response was in order, the degree of the expansion and the assertion of new powers the Fed was never meant to have were way beyond what was necessary. Now the Fed finds itself in a predicament: Having overreacted to the crisis last fall, it now must defuse a monetary time bomb.
The problem is that the Fed enormously expanded the quantity of reserves that commercial banks hold. Since the banks are hesitant to lend in a recession and the Fed is paying interest on them, right now the reserves are sitting there ticking away. But that can change. Those reserves are the basis for loans that banks can potentially make. The larger the pool of reserves, the more loans — which means the larger the money supply can grow. And that means high rates of inflation are a serious threat.
The Fed’s problem is how to get rid of those reserves and avoid inflation. Normally when the Fed wants to reduce bank reserves it sells U.S. Treasury bonds to banks or intermediaries. As buyers pay for those bonds, the Fed reduces their reserve accounts. This is easy enough to accomplish when it involves small changes in the level of reserves.
But to reduce the tens of billions of additional reserves sitting out there right now would require a massive sale of bonds. The problem with doing so is twofold. First, it requires buyers. Given the indebtedness of the federal government at the moment and the rather precarious state of the U.S. economy, are there people willing to buy that quantity of government bonds? The economist’s response, of course, is to say “perhaps, at the right price.”
That raises the second problem: If the only way to sell those bonds is to cut their price, that will mean a dramatic increase in interest payments — the interest payment being the difference between the face value and the price paid. This will only add to it to an already enormous deficit, not to mention raising the cost of borrowing across the private sector as well.
It is not clear at all how the Fed will extract itself from this situation, just like it is not clear how, or even if, President Obama will extract us from Afghanistan and Iraq. The absence of credible exit strategies in all these cases is a consequence of the rush to action in the wake of a crisis, real or perceived. Politicians and central bankers love to “do something” when faced with a crisis, and since doing something is politically better than doing nothing, quick action is often taken without thinking through all the possible consequences. Like the person who paints a floor and ends up painting himself into a corner, both the Pentagon and the Fed have, in their haste to do something, created a situation where there is no exit strategy that doesn’t involve making a real mess. In this case, though, the Pentagon’s mess will fall on the backs of the innocent citizens of two decimated countries and the Fed’s mess might do serious damage to the U.S. economy.
As noted in the movie War Games, sometimes the only way to win a game is not to play. And sometimes the best exit strategy is not to enter in the first place.