Why the Fed's Next Act Could Be Its Hardest

For more than a year, central bankers from Washington to Warsaw have kept the world economy on life support by pumping massive amounts of liquidity into the global financial system. Now comes the hard part: Removing the tubes without killing the patient. For 2010, the hot topic for the guardians of financial stability will be how to engineer an exit strategy that reduces the burden on the taxpayer without risking a double-dip recession. Stock investors seem increasingly confident that it can happen, but it's far from certain such a delicate procedure can be successful.

The amount of stimulus thus far is staggering. The Federal Reserve and other U.S. agencies have lent, spent, or guaranteed $8.2 trillion in emergency funds to resuscitate growth. The Fed's balance sheet has picked up $2.24 trillion of assets, a gain of 142% since the beginning of 2008. U.S. public debt has surged to $7.7 trillion, according to the Treasury Dept., up from $6.4 trillion a year ago and from an average of $5 trillion in 2007.

Efforts by central bankers to turn off the financial spigot are focused so far on esoteric corners of the money markets. The Fed, for example, plans soon to phase out both its Term Securities Lending Facility and its Primary Dealer Credit Facility, which loaned money to banks in return for taking their distressed assets as collateral. A bunch of other acronymic funding channels unveiled during the crisis will also close.

Meanwhile, the European Central Bank in December changed the terms of the 12-month loans it has been making to banks. The ECB switched to a floating rate tied to its policy benchmark, from a previous fixed rate of just 1%, to ensure that banks share the pain once it decides to start driving up borrowing costs. The Bank of England, which has been buying company debt as a way of funneling cash into the system, said last week it will start offloading some of those bonds in January to boost trading.

That kind of technical tinkering at the edges, while essential, avoids the big question: When will central banks start to raise the interest rates that affect the lives of the ordinary folk who have often unwittingly—and perhaps unwillingly—underwritten these trillion-dollar safety nets?

For now, at least, the financial futures market is convinced lending rates will hold steady. The dollar futures contract that settles in December 2010—a guide to where traders expect three-month borrowing costs to be at the end of next year—shows a rate of about 1.4%. While that's way more than the current 0.25% cost of borrowing the U.S. currency for 90 days, the futures level has been ticking down since midyear and is more than a percentage point lower than it was in August.

It's a similar story in other currency markets. Buyers of the December 2010 euro contract have reduced their bets on where three-month money is headed to 1.7% from 2.6% four months ago; the British pound version is down to 1.9% from 2.4% two months ago.

Traders are forecasting lower rates even as the equity market suggests the global economy is mending. One reason: stubbornly high unemployment, which could stay the Fed's hand. In fact, a recent Bloomberg survey of economists found the Fed isn't expected to start raising its target rate until the third quarter of 2010.

The risks of getting the timing wrong are considerable. If the Fed abandons its zero-interest-rate stance too soon, it could ruin a recovery that is already undershooting economic forecasts, with gross domestic product growing just 2.2% in the third quarter, slower than the 2.8% expansion initially reported. Wait too long, though, and cheap money might inflate new asset bubbles of the kind that led to the credit crisis in the first place.

That's why Pierre Cailleteau, a managing director at Moody's Investors Service (MCO), believes 2010 will be "tumultuous" for government risk. "The key policy challenge facing advanced economies is to time the exit perfectly," he says. Perfection, unfortunately, isn't a hallmark of economic governance.

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