In a WSJ op-ed this morning, Federal Reserve historian Allan Meltzer is not optimistic about the prospects for the central bank to "thread the needle" when it comes to removing the massive amount of liquidity that has been injected into the system in recent years.
Federal Reserve Chairman Ben Bernanke has explained his exit strategy to prevent future inflation. The Fed recently began to pay interest to banks on the reserves they hold in their vaults. Using this new tool, it claims the ability to get banks to keep the money instead of lending it out, thus containing the money supply and inflation.
I don't believe this will work, and no one else should.
The exit strategy is incomplete. Proponents are guilty of practicing economics without prices. They never say what the interest rate on reserves must be to get banks to hold the approximately $1 trillion of reserves above the minimum they're legally required to hold. That's the critical question.
The efforts to reduce inflation during the 1970s failed because they ended prematurely. And they ended prematurely when business, unions, Congress and the administration objected loudly to the rising unemployment accompanying higher interest rates. Today's high current and prospective unemployment rates pose a similar dilemma.
Based on where we are find ourselves today, the chances of commodity-driven inflation rising rapidly in the years ahead would seem to be far greater than for employment to do the same, all of which makes the Fed's job of balancing it's two aims - stable prices and low unemployment - much more difficult no matter how they go about doing it.
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