The Fed's Exit Strategy: Local Lanes or Express?

Federal Reserve Chairman Ben Bernanke is delivering his semi-annual Humphrey-Hawkins testimony about the economy before the House Financial Services Committee today and he will repeat the performance before the Senate Banking Committee tomorrow.

Investors and economists alike would like some indication that the emergency measures that the Fed took over the past year will eventually be reversed, lest those very actions start stoking future inflation. How exactly will the Fed stop pumping money into the economic system?

We discovered the answer in Bernanke's op-ed in today's Wall Street Journal. "The Fed's Exit Strategy" outlined a number of ways that the Bernanke and company plan to extract liquidity from the system. That's all well and good, but when does Bernanke think that will occur? He noted that:

My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. The Federal Open Market Committee, which is responsible for setting U.S. monetary policy, has devoted considerable time to issues relating to an exit strategy. We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.

Not to be a curmudgeon, but when exactly has the Fed been able to perfectly time its actions? Central bankers are notorious for overshooting the extremes of economic cycles. How will the Fed know when to exit? It's all well and good to say, "hey, check out this neat toolkit--we have lots of different ways to suck all of that money out of the system," but equally important is knowing when to haul out those shiny tools.

It was awfully nice of Mr. Bernanke to tell us not to worry--the Fed bankers will know just when to step on the brake, but given the Fed's actions and missteps over the past twenty years, investors and consumers would be wise to be skeptical of their ability to know whether to take the local or express lanes to exit.

Image by Flickr User Friggy 30, cc 2.0