The Fed's challenge: Timing a graceful exit

(breakingviews.com) -- Ben Bernanke is showing us the door. In a newspaper editorial and Congressional testimony on Tuesday, the Federal Reserve chairman detailed the central bank's strategies for sucking excess liquidity out of the economy when it begins to recover. His stratagems make sense, but will require expert timing.

The new emphasis on exit strategies is encouraging -- it shows the Fed has removed its deflation-fear blinders and is acknowledging the potential inflationary risk from its massive liquidity infusions.

Of course, as Bernanke rightly notes, a lot of the Fed's emergency lending facilities will wind down naturally as the economy recovers, since they have onerous pricing and terms. Indeed, its loans outstanding have dropped from $1.5 trillion in January to under $600 billion now. That amounts to the central bank tightening monetary policy even without raising interest rates.

One other trick will be to unwind the Fed's moves to boost the money supply through what's known as quantitative easing. A big component of this involved effectively buying securities from banks and crediting the proceeds to the reserve accounts they hold at the Fed -- thereby, essentially, creating money without actually printing it. The reserves were meant to be available to back loans, but instead they've piled up. The excess reserves created in this way recently topped $800 billion, up from only a couple billion before the crisis.

As and when banks regain their appetite for lending, putting these reserves to work would expand the real money supply, which in turn could threaten to cause inflation.

To avoid this, Bernanke says the Fed can use its relatively new authority to pay interest on reserves. Increasing the rate from the current 0.25% would make it more attractive for banks to keep reserves on deposit, giving the Fed the time to drain these funds by selling securities back to the banks.

But if loan floodgates opened faster than expected, the Fed would be faced with the unpleasant prospect of having to crank rates up quickly. That would require lockstep increases in the central bank's key Fed funds target rate -- perhaps to levels that might threaten any nascent economic recovery.

Given banks' ongoing risk aversion, the Fed will probably have the luxury of tweaking rates rather than making market-jarring changes. And perhaps the central bank will prove able to finesse the balance between growth and inflation this time around. Unfortunately, it has a poor record of exiting gracefully.