Hints of Recoveryand Fears of Inflation

Investors are right to fret over whether the Fed will be able to mop up the excess liquidity now being pumped into the economy

Since the financial and economic collapse last September, policy decisions at the Federal Reserve have been a one-way street. The Fed has pumped a massive amount of funds into the markets in an effort to keep the economy out of the abyss of deflation and assure enough monetary fuel for an economic recovery. There has been no need to watch out for oncoming traffic—in the form of future inflation. Now the trip is starting to get interesting. Amid hints that the economy is beginning to stabilize, concerns are growing about the Fed's ability to withdraw all that excess liquidity, while avoiding a crippling bout of inflation.

This exit strategy has occupied a "significant portion" of recent policy deliberations, Fed Chairman Ben Bernanke said in a recent speech, and it was undoubtedly a hot topic at the Apr. 28-29 meeting of the central bank. Knowing when to tighten the monetary screws is always a tough call, even for traditional interest-rate policy. Up to now, the past has offered a road map. However, policymakers have no such framework to guide their current unconventional strategies, which greatly increases the risk of a policy mistake.

The markets are already getting a little nervous. Demand for five-year Treasury Inflation-Protected Securities (TIPS) was very high at the Apr. 23 auction. Also, the spread between the yields on a regular 10-year Treasury note and a 10-year TIPS note has widened in recent weeks, suggesting rising expectations of higher inflation.

The Fed's balance sheet has already more than doubled, to $2.2 trillion on Apr. 22. Under normal financial conditions, as lending multiplies the impact of all that monetary raw material, the money supply would be twice its current $8.4 billion. As it is, that multiplier effect is muted, since banks are not lending out those funds as they normally would. Still, the inflation potential is clear, especially since policymakers have already committed to additional purchases of a variety of securities that would balloon the Fed's balance sheet to around $4 trillion.

At the same time, recovery talk has been picking up. Although the economy continues to contract, recent data offer clear signs that the weakness is fading. First-quarter real gross domestic product shrank 6.1%, about the same as the fourth quarter's 6.3% drop. However, the falloff in overall private-sector demand moderated notably. Consumer spending actually rose 2.2%, and April consumer confidence jumped. A record $103 billion inventory liquidation accounted for 2.8 percentage points of the GDP shrinkage, presaging a pickup in production later this year. Plus, housing starts and sales, so central to this recession, appear to be leveling out.

The Fed has plenty of tools to sop up the excess, especially if it gains congressional approval to issue its own debt. Selling riskless "Fed notes" would effectively drain funds from the banking sector. Other methods include increasing the rate the Fed pays banks to hold their excess funds at the central bank, instead of lending them out, as well as traditional hikes in the Fed's target interest rate.

Moreover, many of the Fed's short-term liquidity programs will simply die away as obligations expire or as new borrowing is no longer needed. Already, these programs have shrunk by more than $400 billion so far this year, but that decline has been offset by the Fed's increased purchases of longer-term assets, such as mortgage-backed and other asset-backed securities.

The real question is: Will the Fed have time to execute this daunting mop-up operation? Most economists think it will. When this recession is over, GDP will be about 7% below where it would be if all workers and equipment were fully employed. Until that slack is used up, inflation cannot take root. Even growing at 4.5% annually, which is far faster than anyone expects, it would take the economy three years to reach that point. It's a strong argument, but with all that monetary fuel sloshing around just waiting for a spark, investors still have every right to be wary.

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