The Fed’s Exit Strategy

Allan Meltzer had an op-ed in the Wall Street Journal the other day in which he argued that the Fed’s exit strategy will fail. Here is an excerpt:

Federal Reserve Chairman Ben Bernanke has explained his exit strategy to prevent future inflation. The Fed recently began to pay interest to banks on the reserves they hold in their vaults. Using this new tool, it claims the ability to get banks to keep the money instead of lending it out, thus containing the money supply and inflation.

I don’t believe this will work, and no one else should.

Meltzer and I likely disagree on when the exit strategy needs to begin, however, we are in agreement that the strategy will not work. The banking system is currently flooded with excess reserves — over $1 trillion. Historically, that figure has been around $1 billion or less. Thus far this has not led to inflation because of the declines in velocity and the money multiplier (for more on this see here and here). It is only a matter of time before confidence re-emerges and banks start lending these excess reserves.

When this happens, monetary policy will have to respond by draining these reserves from system. It is possible to do so in one of two ways. The first way is to sell bonds through open market operations. The second way is the raise the interest rate that the Fed currently pays on reserves. While I have no doubt that the latter is possible, it is a much trickier assignment and only tackles the problem indirectly. If the problem is with reserves, the Fed should tackle the problem directly.

2 responses to “The Fed’s Exit Strategy

  1. Pingback: The Fed’s Exit Strategy, Again | Reaction Radio

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