Today, chairman Bernanke presented to the House a plan of phased
withdrawal of the extraordinary monetary stimulus from the
financial system. I have linked to it here. It is an important
document and has the merit of being easy to follow. I discuss some
of my impressions below.
The plan is to end all stimulus programs by the end of Q1 '10. The
focus then will be on managing down the $1.1 tril. of excess reserves
as the economy continues to recover. The control levers for the
plan are term deposits offered to banks which "lock up" reserves,
the rates paid on reserves and on the deposits and a return to
normal discount window function. The Fed will also use "reverse"
repurchase agreements to drain reserves as needed to keep the
management of the special CDs to banks in trim. At the same
time, the Fed will conduct normal open market operations in
the overnight market. So, you will have to watch Fed Funds rate,
the rate paid on reserves, the term and rate structure of the CDs
and the discount rate as well as the repo operations.
It would be wise for the Fed to put this approach into practice
before the banks begin to lend more aggressively, although it is
not necessary. As short term credit demand expands, the Fed
plans to drain excess reserves permanently in an orderly
manner underneath the structure it has in place to manage the
reserves. I am guessing the Fed will ultimately drain about
$900 bil. of excess reserves, and allow the remaining $200 bil.
to flow into permamnent reserves as private sector credit demand
expands. Timing is uncertain.
Should banks exit the CDs at a rate faster than the Fed plans, it
will have the reverse repo facility at hand to counter the move.
The Fed will expand the dealer network it uses to engage in the
repo program and It appears confident it can generate large
enough volumes to do the job.
So, we are in for a period when there are more important moving
parts in the conduct of monetary policy, and my concern will be
how well the Fed balances the need to keep the system liquid
against eventual constrictions on credit. It is all well and good
to fight inflation, but not at the expense of too heavy a drain on
simple monetary liquidity. We've seen enough of that.
The operatiion of the plan will be reported on a timely basis and
will be sufficiently transparent to allow interested parties to see
just how the Fed is proceeding. Much of the dumb stuff published
about the alleged consequences of the Fed's actions for inflation
etc. can be safely ignored in place of observing what the Fed is