The Fed’s Exit Strategy

Ben Bernanke, Chairman of the Federal Reserve, recently offered insight on the Federal Reserve’s exit strategy should price inflation become a concern. He offered two possible options: First, to pay interest on reserve balances held at the Federal Reserve. Second, to reduce the stock of reserves.

Unfortunately, the first option will only postpone the inevitable problem, which is the unprecedented increase in the money supply. Bernanke argues that what the Federal Reserve is doing is “creating bank reserves,” and that the reserves aren’t “chasing any goods.” However, banking institutions will not sit on their reserves forever. As the economy recovers, the Federal Reserve will be required to pay increasingly higher interest rates to compete with returns offered by private enterprise. Although paying interest on reserve balances postpones price inflation in the near term, the policy will eventually lead to increased price inflation in the long term as the money supply continues to increase.

The Money Supply

The second option will not work either. The Federal Reserve will likely be unable to withdraw the necessary amount of reserves from the system when the time comes. After all, their exposure to ‘legacy’ assets (i.e., toxic assets) has exploded since the beginning of the year.

Flooding the market with these worthless assets would cause their price to collapse, which is precisely what the Fed would like to avoid. Granted, the Federal Reserve has other avenues for which reserves can be withdrawn–I will delve into those at a later date.

If the Fed were truly interested in aiding the economy, it would step back and allow the free market to work. Instead, the Federal Reserve continues to appease special interest groups while ignoring the inevitable and disastrous consequences of their deeply flawed monetary policy.

Now, more than ever, is the time to audit the Federal Reserve.

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