Bernanke has one eye on inflation, and one eye on the exit

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As Ben Bernanke makes what could be his final report to Congress this week, his focus, ironically enough, is on exit strategy. The Federal Reserve Chairman's recent piece in The Wall Street Journal, like today's report, notes that the economy has not yet turned around, but the Fed is already anticipating the steps that it will need to take to ensure that recovery is healthy and measured.

Conventional wisdom holds that deep recessions lead to steep recoveries. However, looking ahead to the next two years, it seems unlikely that this will be the case. Unemployment is expected to increase in 2010, and GDP growth next year will probably be weak. Clearly, the Fed still needs to encourage recovery strongly.
The Fed has done so by loaning $1.1 trillion over the past year; by the end of 2009, it plans to purchase up to $1.25 billion of mortgage-backed securities, $200 billion in federal agency debt, and $300 billion of long-term treasuries. These activities, taken in concert, have pumped bank reserves full of cash and promise to further increase available money.

Banks have largely been sitting on these reserves, which means that federal funds have not translated into increased lending, and thus have not led to economic growth. As the economy recovers, however, Bernanke predicts that banks will find places to invest money, which will result in credit easing and economic growth. At that time, if the Fed's current lending practices have not changed, the market will be flooded with money, resulting in inflation.

Bernanke insists that this will not happen, as the Fed will pay interest on reserve balances and increase the target for the federal funds rate. These two actions, taken in concert, will slow lending and thus reduce the flow of money into the economy.

While out of control inflation would be horrific, the other extreme is equally bad. In 1937, as the Great Depression was easing, the government slowed the flow of money, in hopes of protecting against inflation. Today, most economists agree that this was too much (or too little), too soon, and actually caused the Depression to last longer than it otherwise would have.

Bernanke ended his remarks by praising Congress for continuing to ensure the autonomy of the Fed -- and, incidentally, demonstrating the dangers of limiting that autonomy. Noting that "reviews may be initiated at the request of members of Congress, reviews or the threat of reviews in these areas could be seen as efforts to try to influence monetary policy decisions." Bernanke notes that this "perceived loss of monetary policy independence" could have dire consequences, including raising fears about inflation, increasing "long-term interest rates," and destabilizing the economy. Although he promised to give Congress the information it "needs," Bernanke also made it clear that he intends to aggressively protect Fed independence.

Ultimately, for all its threats and dire predictions, Bernanke's statement was intended to let Congress know that his is a steady hand on the wheel. Suggesting that he is neither overeager nor inattentive, he tried to convey that he will not let the flow of money continue too long, nor will he end it prematurely. In a broader context, his final message seemed to be that, of all the candidates to run the Fed, he is best prepared to steer the economy through the rough shoals of the next few years.

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