Tuesday, July 21, 2009

Ben Bernanke's Plan To Prevent Inflation

Ben Bernanke outlined his plan to prevent inflation in an article in the Wall Street Journal. While this plan sounds good on paper, economist Mark Thoma from Economist's View warns that the Fed can not raise interest rates too soon and risk sending the economy back into recession. See the following post on this topic.

Ben Bernanke says that when the economy starts to recover, the Fed will take the steps needed to prevent an outbreak of inflation (the substance of the arguments can be found in the full version):

The Fed’s Exit Strategy, by Ben Bernanke, Commentary, WSJ: The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the ... federal-funds rate ... nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets...

My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem... We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.

The exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds ... ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. ...

But as the economy recovers, banks should find more opportunities to lend out their reserves. That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—unless we adopt countervailing policy measures. When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy. ...

[W]e have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination. ... [T]hese policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

As I've said many times, I'm not particularly worried about inflation, reserves can be removed or neutralized as described. The worry is not so much that they will be too slow at removing reserves, it's that they will get trigger happy and start raising interest too soon potentially stalling the recovery or perhaps even sending the economy back downward. The Fed will need to be sure that things are getting better before beginning to raise interest rates, that's why it's good to hear them use the phrase "extended period" twice when describing how long interest rates will stay low. But there are long lags associated with monetary policy, and by the time the Fed knows for sure that economy is heading solidly in the right direction, it won't have much time left to reverse course and begin removing reserves. Even so, they need to be patient and avoid the more serious mistake of raising interest rates too soon.

This post has been republished from Mark Thoma's blog, Economist's View.

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