Does the Fed Need an Exit Strategy?

End the Fed Ron Paul Best Price: $1.12 Buy New $8.53 (as of 10:10 UTC - Details) In a recent article, Paul McCulley, managing director of PIMCO, was very enthusiastic about Bernanke’s handling of the financial crisis, and argued that the Fed had the tools necessary to avert large price inflation. Unfortunately, McCulley’s arguments have gaping holes; he has hardly dispelled my prediction of massive stagflation. Because McCulley’s piece crystallizes what many analysts have been saying, it will be instructive to pick apart his main points. No Need for Fed to Soak Up Reserves?

McCulley’s most significant claim is that the Fed will be able to hike interest rates without selling off the assets on its balance sheet:

[T]his is really, really important stuff to understand, given the widespread yammering about the need for the Fed to have an exit strategy to de-create all the excess reserves it has created, as if they are intrinsically the kindling for an (eventual) rip-roaring inflationary fire. They are not….

It is … simply wrong to get wrapped around the axle about the amount of excess reserves in the system. The Fed now has the ability to hike the Fed funds rate, despite a huge reservoir of excess reserves, because it now has the legal ability to pay interest on those reserves.

Before evaluating McCulley’s claims, let’s set the context. Since the summer of 2008, Bernanke has more than doubled the Fed’s balance sheet. In essence, the Fed wrote checks on itself — drawing on money created out of thin air — in order to buy mortgage-backed securities and other “toxic” assets from financial institutions that had made horrible investments during the housing boom.

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When the Fed buys (say) $10 million in mortgage derivatives, the asset side of its balance sheet rises by $10 million. The seller of the mortgage derivatives — let’s call him Joe Smith — deposits the Fed check in his own bank account. Thus Joe Smith’s checking account balance goes up by $10 million, while his bank itself clears the check with the Fed, so that the commercial bank’s reserves (on deposit with the Fed) also go up by $10 million.

Under normal circumstances, the process wouldn’t stop there. As many readers will recall from (horribly boring) principles lectures, our fractional-reserve banking system leads to a multiplier effect. The initial injection of $10 million into the banking system cascades into a much bigger expansion of the money supply held by the public. Specifically, what normally happens is that the commercial bank makes additional loans because of the increase in reserves.

Remember that banks only need to have a fraction of their customers’ checking accounts “backed up” by either cash in the vault or reserves on deposit with the Fed. So in our example, Joe Smith’s bank saw its reserves go up by $10 million, while its total customer deposits also went up by $10 million (in Joe Smith’s checking account). That means the bank now has “excess reserves,” i.e., reserves on deposit with the Fed over and above what it needs to cover its legal reserve requirement.

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