Obama is counting on Bernanke to nurse the economy back to health at a time when unemployment, home foreclosures and bank failures are still mounting.If the economy can recover without mega-piles of excess reserves in the banking system, why did the Fed put the money there in the first place? Is this a kind of Fed hand-holding while the economy begins producing and hiring again?
The Fed chairman has pushed U.S. interest rates to near zero and flooded financial markets with hundreds of billions of dollars to stem a credit crisis and turn back recession.
Bernanke, appointed by President George W. Bush and widely respected as a top scholar on the Great Depression, now faces the challenge of pulling back the Fed's extraordinary support for the economy without setting back hopes for a recovery.
At any rate, the funds are there, by way of a doubling of the Fed's balance sheet over the last year. To keep those funds out of the loan market, the Fed pays the banks interest. A guaranteed interest (currently 0.25%) from the Fed for doing nothing sounds attractive compared to the risks involved in loaning money. But how long can this go on? As Robert Murphy points out, paying interest to the banks increases their reserves, and increases them exponentially.
Bernanke recognizes that at some point banks will want to start lending again, and when this starts to impact the broad measures of money supply, the Fed will swing into battle with its exit strategy. It has various policy tools, all designed to raise interest rates. But if the Fed raises the interest it pays banks on their reserves, thereby setting a floor under the short-term federal funds market, banks will not starve from the decline in lending.
Does that sound reassuring? Will the Fed "tighten monetary policy" just when the (hoped-for) recovery begins to gather strength?