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Published January 14, 2009 at 8:43 AM
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 With the Federal Reserve's balance sheet growing fast, Chairman Ben Bernanke has been accused of basically printing up money to throw at the financial crisis that will come back to bite the U.S. in the form of future inflation. But let it not be said that the country's most high-profile economist hasn't considered that eventuality as well.
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In a speech given Tuesday at the London School of Economics, Bernanke gave some insight into how he expected things to play out once the Fed
is finished putting out fires. First off he doesn't think 1970s-style
inflation is going to show up.
The Fed's lending activities have indeed resulted in a
large increase in the excess reserves held by banks. ... However, banks
are choosing to leave the great bulk of their excess reserves idle, in
most cases on deposit with the Fed. Consequently, the rates of growth
of broader monetary aggregates, such as M1 and M2, have been much lower
than that of the monetary base. At this point, with global economic
activity weak and commodity prices at low levels, we see little risk of
inflation in the near term; indeed, we expect inflation to continue to
moderate.
However, at some point, when credit markets and the economy have begun
to recover, the Federal Reserve will have to unwind its various lending
programs. ... As lending programs are scaled back, the size of the
Federal Reserve's balance sheet will decline, implying a reduction in
excess reserves and the monetary base. A significant shrinking of the
balance sheet can be accomplished relatively quickly, as a substantial
portion of the assets that the Federal Reserve holds are short-term in
nature and can simply be allowed to run off as the various programs and
facilities are scaled back or shut down. As the size of the balance
sheet and the quantity of excess reserves in the system decline, the
Federal Reserve will be able to return to its traditional means of
making monetary policy -- namely, by setting a target for the federal
funds rate. ... We are monitoring the maturity composition of our balance
sheet closely and do not expect a significant problem in reducing our
balance sheet to the extent necessary at the appropriate time.
And if the unwinding doesn't go as smoothly as Bernanke hopes, he
outlined some of the ways the Fed can engineer a soft landing.
However, as excess reserves decline, financial conditions
normalize, and banks adapt to the new regime, we expect the interest
rate paid on reserves to become an effective instrument for controlling
the federal funds rate. Moreover, other tools are available or can be
developed to improve control of the federal funds rate during the exit
stage. For example, the Treasury could resume its recent practice of
issuing supplementary financing bills and placing the funds with the
Federal Reserve; the issuance of these bills effectively drains
reserves from the banking system, improving monetary control.
Longer-term assets can be financed through repurchase agreements and
other methods, which also drain reserves from the system.
- George White
See full speech transcript
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