Ben Bernanke's Exit Strategy Dilemma

The newly reappointed Fed Chairman Bernanke faces a dilemma of whether to keep interest rates low and risk inflation following the massive influx of money into the financial system or to increase interest rates and risk ending the economic recovery. Strong political pressure to create jobs and the currently tame inflation projections will favor the former as the likely choice. See the following post from The Capital Spectator.

Fed Chairman Ben Bernanke will be chatting up the central bank’s exit strategy later this week when he testifies before the House Financial Services Committee on February 10. To say that there are political and economic risks hovering over the subject is to understate the potential hazards.

There are risks to tightening too early, which some worry would repeat the mistakes of 1936-1937, when reserve requirements were tightened and the economy slipped into recession. At the same time, it'd be foolish to discount the potential for higher inflation in the years ahead in the wake of the extraordinary monetary stimulus over the past year or so. Regardless of the economic reality, the political pressure to keep rates low is intense, given the weak labor market.

In late-January, Carnegie Mellon Professor Alan Meltzer bluntly responded to Bernanke’s commentary on the details of an exit strategy by opining that the Fed chairman’s plan is destined to fail. Meltzer, author of a sweeping two-volume history of the Fed (A History of the Federal Reserve, Volume 1: 1913-1951 and A History of the Federal Reserve, Volume 2, 1970-1986), said that Bernanke's plan to prevent future inflation is "incomplete." As Meltzer explains, "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."

Will Ben respond to the criticism and soothe Meltzer's concerns? Stay tuned. For the moment, however, the stakes are low, or so the market outlook for inflation suggests. The Treasury market's 10-year inflation forecast is a modest 2.27%, based on the spread between the nominal and inflation-indexed 10-year Treasuries as of Friday's close.

That's roughly in line with the inflation outlook just before all hell broke loose in September 2008, when Lehman Brothers failed and the financial troubles at the time exploded into a crisis. Among the fallout from the chain of events that month was the heightened risk of deflation. Judging by the market's forecast these days, the deflation risk has faded. Yet the inflation risk at the moment looks tame.

No wonder that the Fed funds futures market anticipates no imminent change in short term rates. If we look out a year, the futures market expects the Fed to raise interest rates, but just barely. The February 2011 contract is currently priced for a roughly 0.75% Fed funds. That's up from the current 0-0.25% target range, but as changes in rate expectations go, that's rather subdued.

Will Ben's testimony on Thursday give us reason to rethink the future of inflation and interest rates?

This post has been republished from James Picerno's blog, The Capital Spectator.