Bernanke Rules?

In today’s Wall Street Journal, Fed Chairman Ben Bernanke has outlined “The Fed’s Exit Strategy.” He tells the reader how the central bank will avoid an inflation of historic proportions resulting from all the money and credit it has injected into the economy. All of the strategies he outlines are technically feasible ways for the Fed to implement monetary restraint.

The op-ed has an air of a classroom exercise, however, rather than a practical central-bank strategy. Much of the article is devoted to explaining how the Fed can now pay interest on reserves, and how it could raise that interest rate so as to dissuade commercial banks from lending the reserves out. It could do that, but what would that rate need to be in order to meet a private bank’s threshold rate of return in normal economic times?

More importantly, the Fed has never lacked the technical tools to combat inflation. What it has so often lacked is the will to make tough decisions. And, quite frankly, it does not possess the information needed to fine-tune the economy in the way Chairman Bernanke imagines (a point made by Milton Friedman many years ago). Lack of will and lack of information combine to keep the Fed behind the curve. Its policy was too easy after 2001, and so it fueled the housing boom. It was late to recognize the turn in housing and the economy, and its policy was then too tight. If past is prologue, it will be late to implement its exit strategy.

The Fed Chairman has presented a laundry list of policy tools. What investors need is some assurance that the right tools will be used at the right moment. The mere promise of a policymaker to do the right thing has little credibility. There is no monetary rule in place, only the rule of a man.