Don’t Count on the Fed to Do it Right

by Inya Ivkovic, MA

The economy is showing timid signs of recovery, which signals The economy is showing timid signs of recovery, which signals the time for the Fed to start thinking about inflation. I believe that last week I dispelled whatever misconceptions we might have had about deflation, but I haven’t dismissed inflation, which might stay put in the short term. However, in the longer term, particularly if the Fed and other central bankers don’t figure out their exit strategies after dumping trillions of dollars into global financial systems, it may rear its ugly head sky-high. Yet, knowing the Fed’s history, I really don’t want to bet on the Fed to do it right and to do it in time.

Granted, every time a recession runs its course, the Fed is put between a rock and a hard place: Should it keep using expansionary monetary policy to keep the economy growing, or should it start tightening the reins to avoid hyperinflation? The first choice is self-promoting and makes for great pictures in the financial press, while the other resembles a self- flagellating choice that only reminds people of the difficult times they believed to be over. But hyperinflation is something that could make self-flagellation nothing more than a light summer breeze against bruised skin.

The Fed and central banks around the world have taken truly extraordinary steps to battle the credit crisis, particularly after taking on billions and billions of dollars in toxic mortgage-backed securities on their balance sheets. But unraveling the entire rescue program could result in hyperinflation that is likely going to be much trickier to bring under control than ever before.

Still, regardless of the threat, I don’t think the Fed will have the guts to do it right. Keeping prices in check after more than a year in recession is not likely to be a popular move, which is again the likely reason that the Fed will lack the resolve to make unpopular choices. Historically speaking, the Fed never failed to take the course of the least resistance, focusing only on putting out current fires and delaying to look further into the future until the future became an unpleasant present. As if diving one’s head into the sand ever solved any problem.

So far, inflation has not made an appearance. The U.S. core inflation rate has declined from 2.4% at the onset of this recession to 1.7% in July on an annualized basis. During the Great Depression, prices plunged for more than three years at an annual rate as high as 10% at times. But that does not mean that tomorrow’s inflation is going to remain tame once consumers return to shops, malls and dealerships. In fact, I believe that, if left unchecked, it will actually go nuts.

Yet, the Fed’s chairman, Ben S. Bernanke, the man who did academic research on what had caused the Great Depressions, is still rambling on about deflation. True, the current price levels are ultra-low and, true, the economy still needs all the help it can get. But without preparing the tools to reverse the effects of monetary easing and strategies to unload the debt-laden national balance sheet, what may come ahead could ruin and/or seriously delay any recovery.

In the past, the Fed’s job was simple. When facing a downturn, lower the benchmark lending rate. When going through a recovery, increase it to curb inflation. But nothing is simple anymore and the limitations of such plain-vanilla monetary policy came to light during the recent recession. It seemed it almost didn’t matter how much money was poured into the global financial and credit system, the economy still kept on sliding into the abyss. Even after the Fed cut its benchmark lending rate near zero, the U.S. GDP still plunged at a 5.5% annual rate in the first quarter of this year

There is one way to deal with the consequences of the easy credit era, which is for the Fed to raise interest rates on the reserves that lenders hold with the central bank. In July, these reserves were about $800 billion, which is a substantially higher figure from the $32.0 billion held in reserve in September 2008. The interest rate so far paid on these funds by the Fed was 0.25%, but it is subject to change at any time.

Now, lenders will draw on these reserves once they feel confident it is safe and profitable to make new loans. But if the Fed increases interest paid to lenders on these reserves, they might be discouraged to lend more when they can earn money doing absolutely nothing. In other words, there is no rule book on managing the money supply with interest rates on reserves and whatever had worked before can no longer be relied upon.

Certainly, we all know that the Fed’s job is not an easy one. But that’s why men like Bernanke are paid the big bucks — to know what to do and when to do it. Sadly, having seen Bernanke and his predecessor Greenspan in action, and knowing what I know about most of the Fed’s past chairmen, I’m not holding my breath.