Ben Bernanke puffed out his inflation-fighting chest in the form of an editorial in the Wall Street Journal.
Bernanke said he expects the weak economy will cause the Fed to keep its foot on the monetary gas for “an extended period.” When the time comes, however, he says he’ll use all the following tools to keep a lid on inflation.
If only it were that simple.
Before we get to why fighting inflation will be easier said than done, here are the tools Bernanke’s referring to.
The problem, Bernanke notes, is that bank reserves have ballooned to $800 billion. Right now, banks aren’t making loans, so these reserves aren’t entering the active money supply. When the economy begins to recover, however, the banks will start drawing down and lending out the reserves, rapidly expanding the money supply and causing inflation.
To combat this, Bernanke says the Fed will:
- Shrink reserves by winding down short-term credit facilities (banks are already using these less: short-term credit is down to $600 billion from $1.5 trillion at the end of last year).
- Shrink reserves by $100-$200 billion a year by allowing securities held by the Fed to mature.
- Tighten monetary policy by paying higher interest on reserve balances, which encourages banks to keep the reserves on deposit at the Fed instead of pumping them into the economy (banks won’t lend out money when they can earn more risk-free by keeping it at the Fed).
- Shrink reserves via four additional mechanisms: Reverse repo agreements Treasury debt issuance (sell debt, take money out of economy, give it to Fed) Offering “term deposits” (like CDs) to banks, which again keeps them from lending out reserves Sell long-term securities into the open market, taking cash out of the economy
- Reverse repo agreements
- Treasury debt issuance (sell debt, take money out of economy, give it to Fed)
- Offering “term deposits” (like CDs) to banks, which again keeps them from lending out reserves
- Sell long-term securities into the open market, taking cash out of the economy
Feel better? Good. There is indeed a lot Bernanke can do to avoid turning your savings into Zimbabwe dollars.
However… it’s easier said than done.
If and when inflation picks up, the economy will in all likelihood still be sputtering along. Unemployment will still be very high, and growth will be sub-par (the dreaded stagflation). Bernanke will be under intense political pressure to keep his foot on the gas until the economy has really and truly recovered, and the history of the late 1930s, when the government slammed on the brakes too early, will be in the forefront of his mind. Bernanke will also have an incentive to keep inflation as high as he can (without spooking our creditors) to reduce the real burden of our debt. All of these factors will combine to make it a lot harder to decide when and how hard to hit the brakes than Bernanke’s explanation suggests.
In short, a big inflation light will not suddenly flash from green to red. Two months ago, when green shoots were in vogue, armchair Fed Chairman had already begun yelling at Bernanke to tighten before it was too late. A month ago, the obsession had once again turned to deflation. Now, with the stock market soaring, we’re all worrying about inflation again (thus the Bernanke editorial). In another month, we’ll probably be worried about deflation again. And so on…
The stagflation of the 1970s was not caused by gross stupidity or incompetence. It was caused by the understandable decision to put the economy–and the lives of real people and the jobs of real politicians–ahead of abstract concerns like the money supply. Unless we somehow do get a V-shaped recovery, which seems highly unlikely, the tough part of Bernanke’s job will not be inventing tools with which to combat inflation. It will be deciding when and how to use them without killing the recovery.
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