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In his first testimony before the 112th Congress last week, Chairman Bernanke gave a testimony before a skeptical crowd of Congressmen. This was a testimony packed with information, easily glossed over by the media, and unfortunately not nit-picked as well as it probably should be. Despite the several foreboding prophecies of epic inflation spreading, Bernanke answered appropriately with one point specifically sticking out to me:

“…we have developed additional tools that will allow us to drain or immobilize bank reserves as needed to facilitate the smooth withdrawal of policy accommodation when conditions warrant…”

What exactly are these “additional tools” and how can the Fed use these tools in order to fend off a swift onslaught of spiking inflation? Well, let’s take a look:

#1. The Fed has recently been granted the authority to pay interest on reserves banks hold. I posted this scary graph in an earlier post last year. Excess reserves have sky rocketed as a consequence of the recession and all of the financial facilities the Federal Reserve has created to buy up toxic assets and shoot liquidity into the financial system. Well, in October this year the Federal Reserve will begin paying interest on these reserves, granting it more control to raise short term rates faster. This idea, spawned on by the likes of Milton Friedman, is one of the primary tools the Fed has gained to control excess reserves and bank lending.

#2. Another change in the Fed’s practices is actually a reverting back to pre-crisis protocol. During the crisis, the Fed expanded the maximum maturity of discount window loans to 90 days from overnight. Now, nearly all discount window loans have reverted back to overnight, and the rate of these overnight loans has increased 50 basis points over the targeted federal funds rate.

#3. Another tool the Federal Reserve is developing is essentially a term of deposit (a CD) in which financial institutions park their reserves in the Federal Reserve and gain interest. This idea is still being analyzed, and the Fed will be conducting test transactions this spring. Chairman Bernanke has confidence in both this term deposit facility and the Fed’s reverse repo agreements with institutions, stating “The use of reverse repos and the deposit facility would together allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quite quickly, should it choose to do so.” The proposal for the term deposit idea can be found here.

All in all, the Federal Reserve has substantially closed down or is winding down facilities it created during the crisis to provide liquidity during the economic downturn. Tools for an exit strategy have already been used, and new weapons to hedge off any spike in inflation are ready to be utilized once that moment may come, which many say the time is drawing near with commodity prices spiking (another argument for another article…). The exit strategy is prepared for this phase, but with the closing of these facilities and the normalization of discount window lending, total credit outstanding has fallen from $1 1/2 trillion in 2008 to $71 billion in March of 2010.

Finally, you can see some of the effects of the unraveling of the different programs created by the Fed during the crisis, and juxtapose it against the insubstantial amount of reserves depository institutions were allowed to hold before the crisis.

Pretty dramatic huh?…

I know, I know, the title to this article in this day and age can be considered Bolshevik propaganda, but hear me (and a few others out) when I say the financial crisis had some conventional (and not so conventional) elements to it, calling for both conventional and non-conventional responses that seem to have been effective up to their boundaries, of course that’s the lower-zero bound.

Anyways, I’ve been hearing a lot of vehement accusations against the Fed over the crisis, most notably they kept interest rates too low for too long. Hence, this led to mis-allocation of capital which proceeded to heat up and inflate the housing bubble like a run-away hot air balloon. On the surface, this makes sense. Just coming out of the recession in the early 2000′s, the logical economic step is to lower the FF in order to stimulate aggregate demand and shift the IS curve (investment and savings equilibrium) to the right. And maybe Greenspan fell asleep at the wheel with the pedal to floor, driving the economic vehicle into an endless financial chasm.

But then I thought, “Surely there would have been more outcry against Greenspan’s policy, and his title of ‘Maestro’ would undoubtedly  been revoked, right?” The problem is that the problem is overstated.

When reading Greenspan’s response to the crisis (found here), I found many things I agreed with. He mentions the conversion of most Third World conversions to Asian-Tigers style export-oriented economies. These economies rely on savings gluts in order to accommodate their competitiveness in the global economy. In essence, “global saving intentions, of necessity, had chronically exceeded global intentions to invest.” Another big point, specifically having to do with the interest rate set by the Fed and it’s correlation to mortgage rates fell to insignificance during the boom years, hence coining Greenspan’s term, the “conundrum”

He notes, “The correlation coefficient in the U.S. between the fed funds rate and the 30-year mortgage rate from 1963 to 2002, for example, had been a tight 0.83……But the 30-year mortgage rate had clearly delinked from the fed funds rate in the early part of this decade. The correlation between the funds rate and the 30-year mortgage rate fell to an insignificant .17 during the years 2002 to 2005…”

So, when the FOMC did target a higher interest rate (which they did), the housing bubble paid no mind to the tightening and continued with more ferocity into 2005-2007, the apex of the housing bubble. Notice the correlation between the chart on interest rates, and the chart on the housing bubble:

So, in essence, demand for housing was fueled by something other than low interest rates caused by the Fed, because nearly all investors understood that the low rates of 2003-2004 was an anomaly.

Michael Woodford revealed a great analysis of this in the Journal of Economic Perspectives entitled “Financial Intermediation and Macroeconomic Analysis” which you can find here.