Does Bernanke Know How to Tighten?

Watching Larry Kudlow interview former Dallas Fed president Robert McTeer this morning on CNBC, this was the (only half) pejorative question of the discussion: Does Ben Bernanke know how to tighten monetary policy since most of what he has done in his tenure is lower rates? Good for a few laughs, the question remains.

Everyone now seems to understand that Bernanke’s current stance on deflation—that it is the worse of two evils—is built out of his Depression scholarship and his eye on the on-going Japanese specter. But now we wonder if he has the wisdom and the will to tighten rates before it’s too late and inflation roars out of control.

Clearly, the encouraging economic recovery data and bubbling asset prices in stocks and commodities will make the Fed’s exit strategy the number one financial issue of 2010. But I have written extensively this year about why all the handwringing in 2009 was premature and unnecessary:

September 9: Don’t Fight Inflation – Buy it! : Asset re-flation has been in full force since early this year, and it’s not over yet.

September 24: Bernanke’s Bet, Bernanke’s Trim Tab: Fed Chairman stays the course, adjusts gradually.

September 30: Inflation and Higher Interest Rates Coming? Still Not Yet: The yield curve sees inside the Fed’s mind.

From Pushing on a String to Pulling on a Spring

In November, I started to look ahead at how the Bernanke Fed will telegraph an earlier shift in policy if the positive economic recovery data continues to surprise. I wrote a piece about the Fed Yield Curve Building an Instability, explaining how quantitative easing (QE) could be “pulling on a spring.”

The dire consequences of massive debt, deficits, and inflation are not new topics for Kudlow or Rick Santelli. But when they were ranting about them last summer, had they gotten their wish and the Fed tightened then, would the recovery have moved from still-very-fragile to arguably-stable as quickly as it as?

All of these questions became especially relevant this morning after initial jobless claims continued to warm our economic hearts, with continuing claims dropping below 5 million for the first time in a long time. Earlier in the week, the talk focused on how inadequate were the Fed’s two recent measures to soak up liquidity—reverse repos and term deposits. These “sponges” are among just a few of the tools the Fed has to drain money from the system as needed and many brighter economic minds than mine are confident Ben and Co. will use them well when needed.

Bernanke’s Sponge and the Politics of Failure

So now I am in the camp that the Fed can tighten rates and roll back QE in the first half of 2010 and we will be okay—as long as these two conditions are met:

1) Economic data about the recovery keeps its steady upward trend

2) Commercial real estate debt bombs don’t cause financial shockwaves that lead to a double-dip recession

McTeer, when asked by Kudlow how soon the Fed will hike, said he is looking at June. I respect McTeer’s cool, plain-spoken approach to all things Fed. Obviously, draining excess liquidity will start before then. And transparent communication about the schedule and pace will hopefully keep the stock market calm and collected.

Since no one is worrying about the amazingly strong stock market anymore, all eyes are on the Fed’s exit from QE. The danger is that Congressional New Year’s resolutions and autumn election dreams interfere with Ben and Company’s measured plans and careful evaluation of the data. I’m far more worried about the politicization of this exit than I am about Ben’s ability to orchestrate it.