The Fed's Game Plan: What Ben Bernanke Is Thinking

Bernanke's game plan is becoming more apparent. Based on a reading of his papers and his public statements, here is a distilled view of what we think is his game plan.

1. Grow the money supply quickly and abundantly

2. Stabilize the Banking System to avoid destructive banking failures

3. Do not withdraw the monetary stimulus prematurely to fight inflation.

4. Manage 'confidence' aggressively to dampen the expectation of inflation later, and a panic liquidation now.

Each of these legs of his policy is a reaction to lessons he believes the Fed learned from the Great Depression.

As you consider the specific things he is doing, it is likely that they will fit very nicely into this framework.

He is obviously fighting the 'last war,' the last great battle that the Fed is known to have waged, and lost. For it did lose, as there was no lasting recovery until the world suffered through the Second World War.

Whether he will be successful or not remains to be seen. It is important to bear in mind that the Fed is absolutely confident that they know how to stop inflation once it gets started, even if it becomes rather serious.

The over-arching theme is that this is an emergency, and so long term niceties like moral hazard and systemic reform will be left for later: the ends justify the means.

William Poole says that this is a dangerous approach, because longer term consequences like inflation appear with a one to two year lag after a significant monetary stimulus such as we have just seen.

The timing of the Fed's dampening of inflation will be critical, and perhaps constrained by the real economy. How can the Fed tighten sufficiently if the real economy remains sluggish?

Bernanke is determined to err on the side of too much stimulus, given the trauma of the Fed's experience in the Great Depression. Coupled with the Fed's confidence in their ability to stop any monetary inflation, this raises a higher level of probability in the most likely outcome of the Fed's latest and greatest monetary experiment.

We cannot help but wonder what he thinks the Fed will be doing this time that will be different than 2003-2007 when they reflated the financial system after a market crash the last time without meaningful reforms, resulting in the stock market and housing bubbles.

Whatever happens, it will certainly provide the raw material for economic papers yet unwritten.