Monday, April 6, 2009

"Good evening, I'm Ben Bernanke and I will be your waiter tonight.

There was a lot of focus on the employment report and the fact that the market, which seems to be forward looking shrugged it off. Perhaps more importantly, and certainly more so for long term investors, were some remarks by Ben Bernanke at a speech in Charlotte and by Donald Kohn in Ohio on Friday about actions the Federal Reserve is likely to take at the end of the current crisis.

The text of both speeches focused on the actions the Fed is taking to mitigate the current crisis with special reference to the programs which expand the Fed’s balance sheet. The short version is that as the credit markets froze up over the course of the past 18 months the Fed has stepped in and taken over some functions of the private financial system in order to prevent a liquidity crisis from causing a systemic collapse. The Fed has been aggressive and creative in the course of taking these actions and is at pains to point out that the vast majority of the assets it has taken onto its balance sheet expose the Fed to minimal risks.

These stories are more interesting for what they did not say than for what they did. The press reports that came out of their speeches were actually focused not on the Fed has done but how it intends to undo those things. Both men said that they were aware that the Fed would face challenges in unwinding these programs once the economy stabilises. I think it is telling that this came out in Q&A rather than in the text of their speeches. Especially Kohn’s as it included a section on policy risks.

Here is the difficulty: the Federal Reserve has stepped into the fray of lending to the private sector and of supporting the borrowing efforts of financial intermediaries as well. This is what has expanded the balance sheet. Some of this has been done through quantitative easing where the Fed simply creates money. Today the Fed and everyone else is primarily concerned with deflationary pressures on the economy in the form of lower wages, higher unemployment and very notably the disappearance of $30 trillion in financial asset values. I have spoke about the inflation/deflation conundrum in previous blog posts.

The Fed may well succeed in avoiding deflation now that they have signalled to the market the extent to which they are willing to go and how much money they are willing to print. The tricky thing will be how they avoid massive inflation once this is all over. In order to do that they will have to take actions to “soak up” all the liquidity they have created to avoid deflation. What that really means is shrinking the balance sheet of the Fed and withdrawing a lot of the guarantees they have made to various private sector players in the economy.

It is easy to say at a press conference years before the fact that this is what you intend to do but it is a different ball of wax when you have to actually do it. The trouble will be in the timing. If the Fed moves to early then the markets may not have enough liquidity to fully absorb the securities the fed sells and take over the funding obligations the Fed has assumed. This means that rates will rise in the economy and potentially kill the nascent economy in the crib.
If the Fed waits too long and inflation gets underway it will take a long time for the political will to form to do the things that are necessary to fight the inflation because those things would have the same effect of killing off the nascent recovery.

You can think of the problem as that of a waiter with a large tray filled with glasses of various sizes. During the course of the crisis they have been filling the glasses with water (money) and since is it them doing the filling and the placement they can adjust fairly easily. Now imagine that someone else (the market) comes and begins removing glasses from the tray but in ways that are unexpected. The fed will have to keep the tray balanced as it unwinds all these things under circumstances of extraordinary uncertainty. No easy task.

I think the most likely outcome is that the recovery we will get from this recession will be very aenemic and so the Fed will most likely wait too long. Inflation will begin and there will not be the political will at the Fed or at the Treasury to aggressively fight the inflation as that would put the economy right back into recession. For this reason I think we are likely to see pretty significant inflation 18 to 24 months from now. Deciding how to protect yourself from that will be a difficult challenge that I will address in my next post.

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