What the U.S. Exit Strategy’s Going to Look Like

The Financial World According to Inya” Column
by Inya Ivkovic, MA

Last week, Federal Reserve Chairman Ben Bernanke finally started describing what the U.S. exit strategy is going to look like; that is, what the Fed plans to do with excess money supply once it is certain that economic recovery has grown its roots deep enough. Bernanke’s plan is to start reining in credit by gradually increasing the interest rates that the Fed pays the banks for their deposits with the central bank. This particular interest rate is directly tied into banks’ prime rate and will, in turn, have an impact on consumer loans. At the end of this chain reaction will be American corporations and consumers who will have to pay more money to get new credit.

Bernanke also appeased any critics that might crop up by saying that any moves in this direction are not going to happen now, but are still months away. For the time being, the Fed wants to see the recovery taking a stronger hold before the taps are shut off and excess money supply is drained out of the financial systems. Withdrawing the stimulus money too soon could trigger more recessionary pressures and that is not something anyone wants right now.

There is one curious thing about the Fed’s decision to increase interest rates on banks’ deposits, and that is the novelty of this strategy, at least in the U.S. Since the 1980s, control over credit has been exercised by tightening or loosening the federal funds rate. Even more curious is that this rate is at almost zero right now, so one would have expected Bernanke to discuss increasing the federal funds rate instead of the rate on banks’ excess reserves. Instead, Bernanke opted for a different approach, one that would actually give an incentive to the banks to keep their money stashed with the Fed, rather than to lend it out to consumers.

Additionally, such a move would boost organic growth of the federal funds rate, because higher interest paid on banks’ excess reserves serve as a stabilizer of the funds rate in times when the financial system is plush with cash, as is the case at the moment. Note that the Fed couldn’t use this measure before, because it was only passed into law in 2008. However, this type of regulation is not a novelty elsewhere in the world. Many foreign banks have used and relied on it, while the Fed clued in only at the height of the credit and financial crisis in October 2008. Considering the subsequent events and decisions, it was better late than never.

By all accounts, removing the huge amounts of bailout money represents the greatest challenge for the Fed and any of its past chairmen, although it is Bernanke who is in the hot seat in his second term that has just commenced. At the crux of the problem is the timing. If bailout money is drained too soon, unemployment is likely to skyrocket. If the bailout money is left in the system too long, inflation could rear its ugly head.

The Fed is considering other options, too. If, for example, increasing the interest rate on banks’ excess reserves does not do its job fast enough, the Fed could drain excess money supply by entering into REPO agreements, whereby it would agree with an appropriate counterparty to sell its own securities and buy them back later.

In any event, I’m relieved to see Bernanke is working on the exit strategy. I was afraid the issue of unwinding the stimulus would drag on until it was too late. I believe we are working with a six-month model here, whereby we could see the first steps taken in an effort to deal with excess money supply in the second half of the year. The fact that the Fed is thinking about it now gives me great comfort; although, I have to acknowledge, this is only the tip of the iceberg and there are a thousand things that could still go wrong before the events of the last 18 months fully unravel.