Kevin Warsh’s WSJ Op-Ed Piece

Financial TV is full of talk about Governor Warsh’s opinion piece in Friday’s Wall Street Journal. One theory is that it was a shot across Chairman Bernanke’s bow. I doubt it, but even if it was in some limited sense, my experience on the FOMC for almost 14 years suggests to me that the following probably happened. Governor Warsh wrote the piece, then showed it to Chairman Bernanke and asked if he was okay with submitting it to the WSJ. Whatever the Chairman really thought down deep, he probably said “That’s okay with me. Go ahead.” This, of course, is only a guess, but an educated guess.

The timing was odd, however, and awkward, for the Governor since it was so soon after an FOMC meeting in which he didn’t dissent. It looks like he’s trying to have it both ways. Of course, it’s always possible that he and the Chairman together are trying to have it both ways.

One phrase in the piece scares me. He said

“. . . policy makers should continue to communicate as clearly as possible the guideposts, conditions and means by which extraordinary monetary accommodation will be unwound, including the removal of excess bank reserves.” [Emphasis added.]

As I’ve written here before, the treatment of “excess” bank reserves is fraught with danger, as the Fed’s experience in the Great Depression demonstrates. The reserves may be excess in the sense that they exceed the amount required by the Fed. However, they may not be excess in the minds of the bankers. Under the recent unusual circumstances, as with the Great Depression, bankers may think extra reserves are needed. If so, premature attempts to drain those reserves may lead to an unanticipated bank contraction. That happened during the Depression when the Fed raised reserve requirements to “mop up” excess reserves.

The Fed has a new tool—the payment of interest on reserves—that may help them navigate around the rocks, but it had better be sure that its view of those reserves is shared by their owners.