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Faith in the Fed: Will They Get It Right?

http://www.fool.com/investing/general/2013/06/14/faith-in-the-fed-will-they-get-it-right.aspx

Morgan Housel
June 14, 2013

Washington Post columnist Neil Irwin stopped by to discuss his book, The Alchemists: Three Central Bankers and a World on Fire. It's a great read on the history of central banks, including how they responded to the financial crisis and the challenges they face in the future.

There are many different approaches the Fed could take when it comes time to "turn the dial" on an exit strategy. In this video segment, Neil explains some of the factors they'll have to balance, with timing being perhaps the most critical. A full transcript follows the video.

Morgan Housel: To the extent that the housing bubble last decade is what got us here, to the extent that that was caused by interest rates being held too low back then, it seems like the history of getting it wrong -- having the tools to do it right, but not the will to do it right -- the history points to the idea that they will not get it right at the right time. What does that mean for us, over the next decade?

Neil Irwin: One way I think that's kind of unfair, people look at, "Oh, well the Fed has gotten it wrong plenty of times." Well, we're only looking at the things that have gone wrong over the last 40 years.

If you look at the last 40 years, we had a giant recession in 2008. We had a mild recession in 2001.

I would argue 2001 they might have gotten the timing about right. Yeah, there was a recession, but it was pretty mild. They started easing policy before ... Paul Volcker in the early 80s defeated the great inflation pretty successfully.

That said, to your question of what does this mean for all of us in the next few years, it means the range of possibilities is pretty wide.

I think because there's this big decision that has to be made, when do you turn the dial and begin the exit, and how quickly do you move in that exit, and how technically do you carry it out -- raising interest rates, versus selling off assets, versus all the different options they have -- those are huge questions.

I absolutely acknowledge, and I think anybody at the Fed who's being honest would acknowledge, getting that timing right is not easy. That means there's a bigger range of possibilities than in a more normal kind of monetary environment.

Morgan: What is the process for the Fed to unwind when it's done? It first has to stop printing, but then to actually unwind, what's the process that it's going to take when it finally decides to ... ?

Neil: You know, they're dusting off that strategy right now, and trying to come up with -- I think it's now a couple years old -- their plan of action, which involved first raising interest on excess reserves, and then later starting to sell off their $3 trillion bond portfolio.

The question is, will they change that sequencing and change their direction?

I view these as fundamentally technical questions, and on the technical stuff, I have greater confidence in the market staff of the New York Fed and the people doing the thinking on this within the Federal Reserve system will come up with the answer, than I do a newspaper reporter like me.

But, I will say the technical question of how you exit is different from the judgment question, the economic question, of when do you begin it, and how quickly do you move?

Morgan: Banks have all this money in excess reserves at the Fed. I'll try, here, to not get too wonky. They have all these excess reserves at the Fed. When people worry about inflation, it is essentially a fear that those excess reserves will be loaned out, make its way into the economy, and spark inflation