Bernanke's exit strategy

As he laid it out in his op-ed in yesterday's WSJ, the Fed's exit strategy looks sensible. I've argued that the exit strategy shouldn't be all that difficult. It should start when it is clear that the economy has come out of the woods (which appears to be the case already), and when risky asset prices start moving higher (of which there is evidence in abundance: equity prices, commodity prices, energy prices, junk bond prices, even commercial mortgage-backed security prices). Stronger markets for risky assets are not only the signal to begin the exit strategy, they also provide the perfect environment, since the Fed needs to sell many hundreds of billions of risky assets to unwind their quantitative easing of last year.

Already the Fed has unwound some of the liquidity additions of last year, as the op-ed explained, but meanwhile they are still buying more Treasuries and MBS. The Fed's balance sheet hasn't shrunk by much so far.

Although the exit strategy is sensible and feasible, it has not yet been executed. As I argued a month or so ago, the Fed should have already started to withdraw liquidity, and every day that goes by that they don't, the inflationary pressures (stemming from an excess of dollars) accumulate. We can already see this happening: the dollar is down over 10% from its highs earlier this year; gold is up over 10%; commodities continue to rise; and the yield curve is very steep. And Bernanke takes pains to say the Fed is not likely to tighten anytime soon.

We are going to need to watch all of these indicators, as well as the changes in the Fed's balance sheet and the money supply numbers, very carefully. There's no reason yet to sound the alarm about hyperinflation, but inflation complacency is not where you want to be. The Treasury bond market cheered the exit strategy earlier this week, but I think that is a naive reaction. T-bond yields are likely to continue to drift higher until the Fed takes some positive action to shrink their balance sheet.

A tighter Fed does not imply higher bond yields, nor do higher bond yields pose a threat to the economy. The bond market actually loves tight money, since that keeps inflation low. In any event, it would be the most natural thing in the world for interest rates to rise as the economy improves, mainly because interest rates are still very low, in a way that makes sense only if the economy remains mired in a funk and deflationary pressures lurk under every rock. The worst thing would be for the Fed to delay tightening for too long, since that would set up an inflationary problem that would push bond yields sharply higher and require a huge Fed tightening and an eventual recession in a few years' time.

Full disclosure: I am long TBT and long TIP and TIPS as of the time of this writing.