Fear in His Eyes: Bernanke Readies The Helicopter

08-08-2010 • EconomicPolicyJournal.com

The Federal Reserve tight money policy may just about be over. As we have been reporting, a Federal Reserve tight money policy has been driving the economy into a second leg of the Great Recession. The Federal Reserve has apparently (finally) caught on that this is the case. FT reports: The Federal Reserve is set to downgrade its assessment of US economic prospects when it meets on Tuesday to discuss ways to reboot the flagging recovery. Faced with weak economic data and rising fears of a double-dip recession, the Federal Open Market Committee is likely to ensure its policy is not constraining growth and to use its statement to signal greater concern about the economy. It is, however, unlikely to agree big new steps to boost growth. Smaller measures to help the economy could initially take the form of a decision to reinvest proceeds from maturing mortgage-backed securities held by the US central bank, thereby preventing the Fed’s balance sheet from shrinking naturally. Take this as though you were overhearing FT/Bernanke pillow talk. It is well known that the Fed uses FT as an early warning alert system to changes in Fed policy (most likely it is Bernanke leaking.) What does this mean? It is not entirely clear, since it is dependent on the maturities of MBS instruments the Fed holds. If sizable amounts come due in the short-term, the additions to the monetary system could be dramatic. (There is no published data as to the maturities of the MBS instruments the Fed holds). Although nothing is published, it is likely that the maturities are quite widely spread, which means that on a short-term basis, this change in Fed policy is not very powerful. It is likely to be just one notch above simple jawboning. What it does mean is there is serious fear in Bernanke's eyes and that at some point Bernanke may go nuclear and lower the interest rate it pays on excess reserves. At such point, inflation is likely to kick in at a much more rapid pace than anyone expects. Once all those who are now holding large cash balances, decide cash is not the place to be, because of an inflation threat (and I am not talking those just holding physical currency but anything in M2), then all hell breaks loose on the inflation front. We aren't there yet, but I can hear the cannons rolling into place.