Good luck to us.
Reprinted from Barron’s:
Escape From Planet ZIRP
By THOMAS G. DONLAN
Can the Fed ever stop stimulating the economy?
A whole lot of worried people, especially investment managers, are asking the Federal Reserve the question Gen. David Petraeus asked about the war in Iraq. “Tell me how this ends,” the general said in 2003 as he led the 101st Airborne Division toward Baghdad.
His ignorance was prescient. The American-led military coalition defeated the Iraqi army, but there was no effective plan for occupying the country or replacing the enemy government. A quick victory turned into a long counterinsurgency.
Petraeus actually went on to help end the U.S.’s role in the war by managing a change of strategy to buy a little peace—a window of opportunity through which the U.S. military could escape before the country caught fire all over again.
Think of Federal Reserve Chairman Ben Bernanke as the general of American finance. He is the boss of the central bank. More than any other financial leader, his policies created the apparent victory over the economy during the recent unpleasantness. To save the world, the Fed bought Treasuries the way the military burned jet fuel and gasoline.
The Fed now occupies the commanding heights of the U.S. economy and doesn’t know how to withdraw. Money markets, bond markets, and stock markets chafe under the thumb of the Fed’s zero-interest-rate policy, known as ZIRP. Values in all three are dependent on the Fed’s continuing to supply free money through quantitative easing, known prosaically as QE.
These have become essential to American finance as we now know it. We have no general but the Fed, no strategy but hanging on.
Wall Street is not an army; it is a mob that sells bonds and stocks and dollars whenever somebody looks up from his array of computer-display screens and asks, “Tell me how this ends.” When Bernanke or some other central banker starts to explain, the mob’s fingers start to move on computer keyboards and markets tank, as happened last week and on May 22, and will probably happen each time Bernanke speaks about trimming or tapering or reducing QE and ZIRP.
For it’s plain to see how this ends—or rather, how it doesn’t end. Under the relentless pressure of free money, the U.S. unemployment rate gradually falls toward the goal of 6.5%. The Fed slows and then stops buying Treasury debt and starts selling its accumulated hoard. Money comes out of the real economy. Interest rates rise, and unemployment rises again. Bernanke’s successor declares the nth stage of quantitative easing and continues to ZIRP the economy for a few more months. Repeat ad libitum, ad nauseam.
As long as the Fed holds responsibility for the economy, the recovery will be fragile. And as long as the recovery is fragile and incomplete, the Fed’s monetary policy will be responsible for boosting the economy.
What’s needed is a new strategy—an escape from planet ZIRP. It will be at least as difficult to manage as the escape from Iraq.
Petraeus directed a surge of military manpower and a surge of bribe money to open the exit window and keep it open long enough for the Americans to declare victory and depart.
The Fed could declare victory and depart from managing the economy, but it would be politically difficult, unless the U.S. hits a fiscal wall.
Maybe the least bad alternative would be for Bernanke to get serious about inflating, creating a false boom in stocks and housing and gold and other assets. He could do that by dropping $100 bills from helicopters or by ceasing to pay interest on excess reserves.
This disaster would leave room for a disciplinarian to reprise the role of former Fed Chairman Paul Volcker—raising interest rates, tamping down credit growth, and accepting the fact that a recession is preferable to endless manipulation of money.
This is neither the easiest nor the best policy. It just provides political cover for a new Volcker to help us escape from planet ZIRP and return to planet Earth.