After more than a year of lax monetary policy and direct capital infusions, U.S. Federal Reserve Chairman Ben S. Bernanke has finally outlined an "exit strategy" that he says will lead to the "smooth and timely" withdrawal of monetary stimulus and keep inflation at bay.
However, analysts say that Bernanke’s exit strategy is far from foolproof and could touch off an inflationary firestorm that hammers the U.S. economy, debases the dollar and sends prices soaring.
Indeed, analysts have long been concerned that Bernanke’s unprecedented effort to boost market liquidity and expand the Fed’s balance sheet would lead to a significant increase in inflation once credit markets return to normal.
The Fed has injected more than $2 trillion into the U.S. financial system, expanding credit through increased loans to banks to provide liquidity. It’s also created the Commercial Paper Funding Facility - which holds $109.2 billion in short-term IOUs issued by corporations - and the Term Asset-Backed Securities Loan Facility (TALF) - which has lent $25 billion to investors to buy securities tied to auto and other consumer and business loans.
The Fed has also lowered its benchmark Federal Funds Rate to a record low range of 0.00%- 0.25%.
As a result, the U.S. monetary base has about doubled during the past two years.
Bernanke acknowledged in the Federal Reserve’s Monetary Policy Report to Congress - as well as in an op-ed piece in Tuesday’s Wall Street Journal and in comments made directly to the House Financial Services Committee - that inflation poses a significant threat. But he has also made it clear that the Federal Reserve has no interest in changing the course of its policy before it is certain that a recovery is underway.
"Economic policy conditions are likely to warrant accommodative monetary policy for an extended period," Bernanke said in the Fed’s report to Congress.
Nevertheless, the central bank leader said he is confident that when the time comes he will have the "necessary tools" to rein in inflation in a "smooth and timely manner."
So what is the Bernanke’s exit strategy? Will it work? And what should investors do if it backfires?
A Look Inside Bernanke’s Toolkit
Bernanke has heard the concerns about inflation and this week he went a long way to address them. The Fed chairman not only addressed those concerns in his report to Congress, he penned an op-ed piece for The Journal.
Bernanke pointed out in each of those statements that some of the Fed’s emergency lending facilities automatically wind down as the economy recovers, because they have onerous pricing and terms.
Short-term credit extended by the Fed to financial institutions and other market participants has already fallen to less than $600 billion from about $1.5 trillion at the end of 2008, he noted.
