What the Fed Could Do If Inflation Ramps Up

Will the U.S. return to the inflationary days of the 1970s? One can never say never, but a lot of things would have to go wrong at the same time. In his July congressional testimony, Federal Reserve Chairman Ben Bernanke seemed fairly sanguine: "In light of the substantial economic slack and limited inflation pressures, monetary policy remains focused on fostering economic recovery," he said. He added that Fed policymakers "expect that inflation will be somewhat lower this year than in recent years, and most expect it to remain subdued over the next two years."

Still, the Fed remains at the ready. The central bank has consistently pursued the goal of price stability, and it had ample opportunity to put its theories to the test in 1980, when the inflation rate averaged 13.6%. So, now that the Fed has injected oceans of liquidity into the financial system, the long-term concern is how that level of money might affect prices.

Standard & Poor's Rating Services Chief Economist David Wyss says the added liquidity has mostly just offset the liquidity that has drained out of the private sector because companies haven't had access to traditional lending. But as that traditional lending becomes more accessible to the private sector, the Fed will need to squeeze out whatever excess liquidity remains in the system.

However, that's easier said than done, notes Wyss. "Monetary policy operates through channels. This isn't magic. You don't just wave a wand," he says, explaining that to drain liquidity, the Fed would need to make an unpopular move of raising interest rates. "And that could become politically difficult, given how big government debt is going to be relative to the budget and to GDP. Congress will be fighting to keep interest rates low. So we're going to have to have someone running the Fed who has a clear idea of what's needed and the courage to raise rates when the time comes," says Wyss. Bernanke's four-year term is up for renewal Jan. 31, 2010, though it's widely believed he'll be reappointed.

Breathing Room for the FedRaising rates is all about timing. The risks are that the Fed will act too slowly, giving inflation time to develop a nasty upward spiral, or that it will act too quickly, stalling economic recovery—or, worse, pushing the U.S. back into recession. Wyss, however, believes the Fed has some breathing room and wouldn't begin to raise short-term rates until the unemployment rate comes down. "The economic and political pressure suggests that it'll be done that way again this time. So I don't see any Fed rate hikes until late 2010," he says. This would likely give a recovery ample time to take root but would begin the inevitable monetary tightening soon enough to keep inflation at bay.

In both his congressional testimony and his July 21 opinion piece in The Wall Street Journal, Bernanke concentrated on how the Fed intended to extricate itself from its current involvement in specific financial markets. He said the rate-setting Federal Open Market Committee (FOMC) believes it's "important to assure the public and the markets that the extraordinary policy measures we have taken in response to the financial crisis and the recession can be withdrawn in a smooth and timely manner as needed, thereby avoiding the risk that policy stimulus could lead to a future rise in inflation." He went on to say the FOMC has devoted "considerable attention to issues relating to its exit strategy, and we are confident that we have the necessary tools to implement that strategy when appropriate."

The pursuit of quantitative easing policies has more than doubled the Fed's balance sheet, with total "factors affecting reserves"—the broad measure of Fed involvement—rising to $2 trillion in the week ending July 22, from $878 billion a year earlier. These facilities need to be unwound as the financial system returns to normal. Some of this will, as Bernanke explained in his Wall Street Journal article, occur naturally. This withdrawal is already happening, especially to the commercial paper facility, where holdings have dropped to $110 billion from $242 billion three months ago. Total short-term credit extensions have dropped to $600 billion from $1.5 trillion at the end of 2008.

Stable Long-Term InflationOther programs will have to be managed more actively. Fed holdings of agency and long-term Treasury debt won't disappear on their own but will have to be run off gradually as the Fed reduces the reserve base, a process that's already beginning. Total reserve bank credit has dropped 8% since April.

The money supply has responded. M2, the broad measure of the money supply and the one that has the clearest relationship to nominal gross domestic product growth, slowed to a 5.4% annual rate in the first six months of 2009 after jumping at a 12.7% rate in the second half of 2008. (It rose at a 6.6% annual rate in the first half of last year.) This pace seems consistent with stable long-term inflation of about 2.5%.

The problem for the Fed will be to tighten monetary policy just when federal debt and interest payments are reaching modern highs relative to GDP and government tax receipts. Recognizing the political pressure he'll be under, Bernanke made a plea in his July congressional testimony to maintain the independence of the Fed against proposed increased oversight of monetary policy because "financial markets, in particular, would likely see a grant of review authority in these areas to the GAO [Government Accountability Office] as a serious weakening of monetary policy independence."