In an op ed to the Wall Street Journal titled “The Fed’s Exit Strategy,“ which was published on July 21, 2009, the Fed chairman Ben Bernanke mentioned an exit strategy that would allow the Fed to tighten the monetary policy so that the huge bank excess reserves held at the Fed will not turn into money supply and find their way into the economy. This op ed rephrases our post titled “Recession, Deflation, Reflation and Inflation in the US Economy: Updated,” which was posted on June 14, 2009.[1]

As was first explained in my post, Bernake’s op ed outlined two policies that the Fed can use to prevent the huge excess reserves estimated at $800 billion from stirring inflation and causing new asset bubbles. These policies include using open market operations to exchange the excess reserves into government securities and paying higher interest rate on those reserves to make the banks keep them longer at the Fed.

The Fed chairman is acutely aware of the huge increase in the monetary base and the potential danger it carries to future inflation. The Fed has designed an “exit strategy to deal with this eventuality. The details of this exit strategy have not been disclosed. But it is well known that the most difficult part of this exit strategy is when to implement it. It may be implemented too early which may choke an infant recovery or it may be put into action too late and then it will be hard to control inflation. This happened in the past and the recent experience with the Fed that brought us to the current crisis proves this point.

Here is a suggestion to the Fed on how to start  the implementation by the end of 2009 which is expected to bring modest positive economic growth. Since the bank excess reserves are $800 billion which are higher than normal as indicated by Bernanke himself, the Fed can start  soon targeting the bank excess reserves to bring them gradually to the normal level by the time the recovery starts, which is predicted to be at the end of 2009. Here the Fed will be targeting part of the monetary base instead of traditionally targeting money supply. As the recovery starts to take traction, the Fed can start raising the interest on the excess reserves as it raises the federal finds rate.  This should be guided by both leading and coincident economic indicators and prices of commodities, particularly gold and oil.

The suggested policy is timely, measured, anchored and proportional. It should keep the Fed from panicking or losing sleep as the recovery comes closer to us. It saves us from a new attack of inflation and a subsequent new Great Recession which the US economy cannot take for the second time.

[1]http://blogs.zawya.com/shawkat.hammoudeh/090614083116/Recession%2C%20Deflation%2C%20Reflation%20and%20Inflation%20in%20the%20US%20Economy%3A%20Updated