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Fed Hedge -- By: Stephen Spruiell

Over the weekend, economist Greg Mankiw posted on his blog a note from a friend who works for the White House. Mankiw?s friend drew a line connecting Obama?s ?populist pivot? following the Massachusetts Senate election to the growing backlash over Ben Bernanke?s reappointment to serve as chairman of the Federal Reserve. He explained that the timing of the pivot and the announcement of new regulations on the banks was purely coincidental. ?This policy process has been in the works for months,? he wrote, adding:

Regardless of how one evaluates the wisdom of the policy (and I fully acknowledge that reasonable people can differ on this), in practice the timing of the announcement (coming after the loss of the Massachusetts Senate seat) is being interpreted as ?the Administration has finally decided to cave in to the populist temptation.? As a result there is a lot of uncertainty about whether Bernanke will be reappointed and whether the new policy signals that the Administration is going to dump him. Honestly, dumping Bernanke was NOT the point of this announcement.

Mankiw?s friend wrote that this could become a ?self-fulfilling prophesy,? however, now that Bernanke is losing support in the Senate.

Here?s what I think: We are looking at rough times ahead for the Fed. In order to stave off catastrophe, Bernanke flooded the markets with liquidity by cutting interest rates to zero, creating an alphabet soup of new lending programs, and going on a mortgage-backed-security shopping spree. This shored up the banks and kept the secondary market for mortgages liquid enough that the housing market didn?t completely collapse.

It also doubled the monetary base. Doubling the monetary base would ordinarily lead to runaway inflation, but most of the money that the Fed has put into the system is still being held by the banks in the form of bank reserves. In other words, the Fed?s actions haven?t led to much of an increase in the money supply.

That could change, however, if banks start lending the money in response to an economic recovery. Ordinarily the Fed could curb the resulting inflation by selling securities, which reduces the monetary base. The problem, as John Carney has noted, is that many of the securities sitting on the Fed?s balance sheet are, to put it bluntly, Fannie Mae and Freddie Mac?s garbage. Who?s going to buy that? Mankiw has argued that the Fed could mitigate this problem by paying interest on reserves to keep banks from lending, but that just postpones the day of reckoning, adds to the monetary base (by the amount of interest paid), and provides a large, politically unpopular windfall for bankers.

Meanwhile, the Fed is scheduled to stop purchasing Fannie and Freddie?s garbage in March. But will it really follow through with this? On the one hand, to keep doing it is madness, for the reasons set forth above. It would put even more money into the economy that the Fed can?t soak back up if inflation hits. But to stop doing it would curtail Fannie and Freddie?s ability to keep propping up the housing market. Mortgage interest rates would rise, foreclosures would rise, and the recovery would be stopped dead in its tracks. You think the political class is mad at Bernanke now? Just wait until that happens.

Which brings us back to the rising opposition to Bernanke?s reappointment. We are headed for a situation in which the next Fed chairman has no good options. Thus, there is little downside to opposing Bernanke now. When the bailout bill comes due, whether it?s runaway inflation or an interest-rate hike that crushes the housing market, a senator who opposed Bernanke?s reappointment can simply point back and say, ?Well, don?t blame me, I voted against the guy who created this mess.? Opposition to Bernanke has less to do with what he?s done -- which most of Congress supported at the time -- and more to do with what he must do in the future.

? Stephen Spruiell is a staff reporter for National Review Online.

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Full post as published by Bench Memos - National Review Online on January 25, 2010 (boomark / email).