What Does the Monetary Exit Path Look Like?

I wish to provoke a discussion in the blogosphere of what economists expect the exit path to look like. John Taylor recently wrote,

assuming the central tendency forecast of the FOMC, the announced buying spree will bring reserve balances to about $4 trillion in mid-2005mid-2015. The risk is two-sided. If the Fed does not draw down reserves fast enough during a future exit, then it will cause inflation. If it draws them down too fast, then it will cause another recession.

Taylor used to be rather highly regarded in the field of monetary economics, but he has fallen out of favor with KruLong, Scott Sumner, and others. Still, I think his concerns deserve a response.

I am not sure what Richard Fisher means by“Hotel California” monetary policy, but it sounds as though he, too, is worried about the exit path.

My response would be that I am not concerned about the inflation-or-recession dilemma. I do not see a knife-edge there. I can picture a gradual transition from high unemployment to moderate unemployment, with inflation rising but staying under control–say, 3 percent. I am not predicting that this will happen, but I can picture it.

But suppose we do reach a point where the Fed has hit its unemployment target and inflation is around 3 percent? And at that point the Fed is sitting on a balance sheet of close to $4 trillion (even if this $4 trillion estimate is off by a trillion or two, we are still talking about real money, if I may allude to Senator Dirksen). And assume that fiscal policy still consists of running huge deficits as far as the eye can see.

When the Fed starts selling securities to limit the rise in inflation, what happens in the government bond market? There I do see the possibility for a knife-edge, or two very different equilibria. There is a good equilibrium in which bond investors remain confident, and rates remain low. There is a bad equilibrium in which bond investors get nervous, and rates jump. A transition to the bad equilibrium is always a possibility–that is what makes sovereign debt crises arise suddenly with no near-term warning. My worry is that a transition by the Fed from buyer to seller in the bond market could be the trigger that sends the markets to the bad equilibrium.

What is the scenario for avoiding the bad equilibrium? Some possibilities

1. No matter how many bonds the Fed sells, markets can absorb it, no problem. Why would this be?

a. Liquidity trap. For those of you who believe in liquidity traps (not my religion, but to each his own), do you think they still obtain when inflation is 3 percent?


b. Rational expectations. Not my religion, either. But you might say that by the time the Fed starts to sell, markets will have already forecast and discounted the Fed’s actions.

2. The Fed can achieve its inflation-stabilization goals by merely selling off teeny-tiny amounts of its bond holdings each year, for, say, twenty or thirty years.

I assume that many (most?) advocates/defenders of the Fed’s strategy believe something like (2). But what is the basis for that belief? We’ve never done this before.

By the way, I will not blame the Fed if this ends badly. To me, the original sin is the non-stop, out-of-control deficit spending. It is really hard to avoid having that end badly, no matter what the Fed does.

Happy holidays.

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10 Responses to What Does the Monetary Exit Path Look Like?

  1. Tyler Cowen says:

    Adjusting the rate of interest on reserves will be an important part of all of this, in other words more fiscal policy, albeit of a somewhat unusual sort.

  2. Joe Cushing says:

    There is no exit because there are not enough buyers for new debt now. There will not be enough buyers for future new debt plus debt the fed is selling. The government cannot meet it’s obligations without printing new money. If it allows rates to clime so that it can burrow money on the market instead of printing, it won’t be able to pay the interest. We are headed for a global currency collapse. This is why there is a TV show called Doomsday Preppers.

  3. Christiaan Hofman says:

    Small typo: I don’t think John Taylor is going back in time.

  4. Todd says:

    In light of your commitment to being generous toward intellectual adversaries, I would suggest that you avoid the epithet “KruLong”. I doubt either would endorse or appreciate it, and it tinges your commentary with an ad hominem element I doubt you intend.

    • Matt C says:

      I have to agree. It’s a pretty mild snark, but still a snark. Doesn’t fit with the mission statement.

  5. Slocum says:

    “To me, the original sin is the non-stop, out-of-control deficit spending. It is really hard to avoid having that end badly, no matter what the Fed does.”

    Yes, but…the totally-out-of-control deficit spending wouldn’t even be possible without the Fed as enabler would it? If the government had to actually sell bonds now to finance the massive deficit, the supply-demand imbalance would likely mean rising interest rates already, thereby forcing Congress and the White House to rein in the deficit. True, we might have a recession. But with the Fed printing money to kick the can down the road, we’re also risking a much bigger disaster eventually.

  6. Floccina says:

    A little off topic but…
    The fed has bought a lot of mortgage backed securities that have been heavily discounted but 3% inflation should make these securities more valuable. Shouldn’t that help.

  7. Ajay says:

    You say that KruLong, Sumner, and others now disregard what Taylor thinks, but does anybody care what they think? Well, other than the dimbulbs in their respective camps that is. I agree that the real problem is out-of-control deficit spending but the Fed is aiding and abetting such wild spending, as Slocum notes, just look at their balance sheet. The Fed has doubled its holdings in treasuries and bought another trillion in mortage-backed securities, mostly from Fannie and Freddie. I do not view these moves as monetary in nature, a mistake most commentators are making. This is fiscal policy executed by the Fed, taking $2 trillion in bad assets off the federal govt’s balance sheet, to make it look better than it is and to keep rates down.

    Of course, it could turn into bad monetary policy if the Fed does not get rid of the $1.8 trillion in excess reserves they’ve electronically created and let that new money into the economy, but I do not think Bernanke is dumb enough to risk that. On the other hand, his term ends in a couple years, the next Obama appointee may not be so bright. As for the scenario where the securities are sold off over decades, I don’t think that will be possible while still disallowing reserves from entering the economy, ie these assets will need to be sold off almost as fast as they were bought. The Fed is taking big risks by entering into fiscal policy like this: that is the danger of Bernanke’s moves, that few are talking about.

  8. Les Cargill says:

    I am sure “Hotel California” refers to the phrase “you can check out any time you like, but you can never leave.” I’m really skeptical that there will be inflation no matter how much liquidity the fed dumps into the markets – at least for a while.

    If the increase in money is expressed as wages, then spending goes up, GDP goes up and The System Works. If it’s not, it gets sloshed around in banks and has no real
    effect. the financial system ( and by extension the government ) is slowly becoming decoupled from the real world economy.

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