"This fear of inflation I think is way overstated," said Fed Chairman Ben Bernanke in the 60 Minutes interview aired on Sunday. "What we're doing is lowering interest rates by buying Treasury securities," he continued. "And by lowering interest rates, we hope to stimulate the economy to grow faster. The trick is to find the appropriate moment when to begin to unwind this policy. And that's what we're going to do."
Bernanke’s word “trick” sums up the issue. As with most other things involving the Fed, the devil resides in the details. And financial markets have a way of tricking the most skilled trickster even when he is the Chairman of the Federal Reserve.
Let’s add another view of this “trick.” In his presentation of the Homer Jones Memorial Lecture, organized by the St. Louis Fed, former Fed Vice-Chairman Alan Blinder set out some of the issues involved in this “trick.” His speech was titled “Quantitative Easing: Entrance and Exit Strategies.” Readers can find the text of the speech on the St. Louis Fed website (link at bottom of this commentary). It is reprinted in the November-December issue of the “Review.”
Cumberland’s chief monetary economist and a former Fed research director, Bob Eisenbeis, has delved into the structural details of exit strategies. Bob’s tutorial is now available on Cumberland’s website, www.cumber.com, in the “Special Reports” section. See: “Fed Exit Strategies - Technical Analysis” (hit control + click to follow link).
Bob’s point is that we are agnostic on whether it can be done. It is important to understand what the technical and practical issues are. Bernanke was asked about inflation risk in the future. He said the Fed could raise interest rates in minutes if it wanted to. However, he did not address the questions that arise when discussing an exit strategy. How would markets react if it came unexpectedly? Moreover, how would markets react to the change in expectations about the future? We have already seen how massive that volatility can be.
There is another piece worth reading on this subject. “Doubling Your Monetary Base and Surviving: Some International Experience” is also available on the St. Louis Fed website. The writers, Anderson, Gascom and Liu, have surveyed a number of central banks and various episodes of large balance-sheet expansion. They show both good and bad outcomes. We suggest readers add this to the list of serous works on the subject (link at bottom).
We are leaving for Europe tomorrow for a fast research trip. At the moment the large central banks of the world are focused on the entrance policy and not the exit strategy. Of the G-4 currencies, lower interest rates are the target for all except Japan. Japan has used quantitative easing for years and is still mired in deflation; the short term interest rate in Japan is zero; the ten year government bond yield is 1%.
Clearly, the US Fed is committed to balance-sheet expansion and is specifically targeting lower rates in the 7 to 10 year maturities. Clearly, the European Central Bank has just extended its special liquidity program and is purchasing the debt of several of the troubled peripheral members of the Eurozone. The yields on government bonds of the peripheral countries are unsustainably high. The Bank of England has already engaged in balance-sheet enlargement.
We expect to have a lot to talk about with our economist, asset manager, and central banker friends. A full schedule of private meetings is now set in London and Paris. We will offer some comments as guest host of CNBC Worldwide Exchange on Friday, December 10, between 5 and 6 AM New York time.
Stay warm. We will try to do the same.
