It will take an adroit Fed to soak up excess liquidity at the right moment to avoid fueling inflation or sinking back into recession
There's an old saying on Wall Street: Don't fight the Fed. With its power to create money, the Federal Reserve has virtually unlimited resources to achieve its goals. That clout was in full view on Mar. 18, when policymakers made the surprising move to start buying $300 billion in longer-term Treasury securities and to more than double their commitment to purchase federal agency debt and mortgage-backed securities, from $600 billion to $1.45 trillion. Since the Lehman Brothers (LEHMQ) bankruptcy, assets on the Fed's balance sheet have exploded from $900 billion to $2 trillion, and these newest plans could push the total to more than $4 trillion. Policymakers are clearly serious about their pledge to "employ all available tools" to promote a recovery.
But at what cost? The danger is that inflation ultimately will surge before policymakers can sop up all the excess liquidity they have created. In normal times, all those funds sloshing around would have the capability of boosting the money supply by several multiples of that amount—a sure recipe for inflation. As already reflected in the recent sell-off of the dollar and the rise in gold prices, the Fed's aggressive actions could create self-fulfilling expectations of future inflation.
For now, though, times are hardly normal. With capital scarce and loan demand weak, banks are letting these funds just sit around on deposit at the Fed instead of using them to make loans that would juice the amount of money flowing through the system.
But that could change quickly. The stock market's powerful endorsement on Mar. 23 of the Treasury Dept.'s plan to relieve banks of $1 trillion worth of "legacy" assets was the first hopeful sign that the banking system can begin its healing process. Other massive policy efforts to open up credit markets and revive housing and the broader economy are lifting the chances that at least a modest economic recovery can begin later this year. Surprisingly strong February home sales may be an early sign of stabilization in housing.
Most analysts believe the Fed will have plenty of time to take back its excess funds without fueling inflation or disrupting markets. But it will be a delicate maneuver that the Fed has never attempted before. Much will depend on the strength of the recovery. If the upturn is as tepid as expected, the pressure on inflation will be downward for a long time.
That's because the recession has created enormous slack in the economy in terms of unemployment and excess production capacity, which is weighing heavily on pricing power and wage growth. Even after the economy starts growing again, many economists believe it could take a couple of years to return to full employment of labor and capital, generally defined as about a 5% jobless rate and about an 80% utilization rate of industrial capacity. Right now, unemployment, at 8.1%, is likely to rise throughout 2009, and the industrial operating rate is a record low 67%. However, if policy efforts turn out to be more potent than expected, that slack could get used up much more quickly, and pricing pressures would rise sooner.
As banks and the credit markets stabilize, the Fed's aggressive funding will work into the system in a more stimulative way. At that point the Fed will have to start shrinking its balance sheet in order to drain the excess funding from the system. Some of that reduction will happen automatically—a large share of the Fed's assets are short-term loans and will simply expire. Further reduction will occur as the Fed begins to hike its target interest rate.
Perhaps the biggest potential problem is that the Fed also plans to hold a large volume of longer-term assets, such as mortgage-backed securities and Treasury notes. These will take much longer to unwind because rapid sales could push up mortgage rates and other borrowing costs. Ultimately, finding the right level for its target rate, plus the right rate of reduction in its balance sheet, will be a touch-and-go decision. A miscue could either send the economy back into recession or let inflation spiral out of control.