Bernanke Swears He Can Do It

Today, Federal Reserve Chairman Ben Bernanke testified before the House Financial Services Committee in his semiannual appearance required by the Humphrey Hawkins Act. One question on the minds of many -- especially Republicans -- is whether the Federal Reserve can eventually tighten monetary supply to avoid inflation. In fact, Bernanke wrote an op-ed for the Wall Street Journal today addressing an exit strategy to do exactly that. I don't have much doubt that he can do it, but that's different from saying that he will do it.

Here's how Bernanke explains he could tighten monetary policy, from the WSJ Op-Ed:

Even if our balance sheet stays large for a while, we have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination.

And from Bernanke's prepared testimony today, some additional detail:

Perhaps the most important such tool is the authority that the Congress granted the Federal Reserve last fall to pay interest on balances held at the Fed by depository institutions. Raising the rate of interest paid on reserve balances will give us substantial leverage over the federal funds rate and other short-term market interest rates, because banks generally will not supply funds to the market at an interest rate significantly lower than they can earn risk free by holding balances at the Federal Reserve. Indeed, many foreign central banks use the ability to pay interest on reserves to help set a floor on market interest rates. The attractiveness to banks of leaving their excess reserve balances with the Federal Reserve can be further increased by offering banks a choice of maturities for their deposits.

But interest on reserves is by no means the only tool we have to influence market interest rates. For example, we can drain liquidity from the system by conducting reverse repurchase agreements, in which we sell securities from our portfolio with an agreement to buy them back at a later date. Reverse repurchase agreements, which can be executed with primary dealers, government-sponsored enterprises, and a range of other counterparties, are a traditional and well-understood method of managing the level of bank reserves. If necessary, another means of tightening policy is outright sales of our holdings of longer-term securities. Not only would such sales drain reserves and raise short-term interest rates, but they also could put upward pressure on longer-term interest rates by expanding the supply of longer-term assets. In sum, we are confident that we have the tools to raise interest rates when that becomes necessary to achieve our objectives of maximum employment and price stability.

This all makes sense. If Bernanke has the will to tighten monetary supply when the time comes, he has the means to do so.

As I've mentioned before, however, there are still two problems to grapple with. I doubt monetary supply tightening will be necessary until early 2010 at the soonest.

1. By then Bernanke could be out of a job if President Obama decides not to give him another term. If that's the case, then the question is moot.

2. If unemployment is still hovering around 10% -- and it probably will be -- then the Fed might have trouble resisting the political pressure to keep monetary policy expansionary.

In a best-of-all-worlds scenario, Bernanke would retain his job and money supply would not need to be tightened until after February 2010. Then, since he already has another term safe, he would be less swayed by political pressure. If monetary tightening has to happen earlier, or if someone close to the Obama administration takes the helm, I'd expect a worse outcome. In those scenarios political pressure would be paramount.

It's hard to determine what economic indicators will be saying in January 2010, to nail down the timing for when to tighten. But it's fun to speculate about what Obama will do. So I thought we'd try something new and let readers give their opinion. You can do so through the below poll. Vote away!