During the credit crisis, the Federal Reserve has gone to unprecedented lengths to provide the financial system with abundant supplies of liquidity. There are two purposes behind these actions: to guard against the risk of systemic failure and to root out the deflationary forces that appeared in conjunction with the risk-abhorrence of last fall. Up to this point, these efforts have mostly worked.
It is likely, however, that this extraordinary exercise in monetary ease will at some point have significant inflationary consequences. And the Fed will face a big dilemma if this happens before the market is restored to stability and the economy has emerged from recession. In this scenario, the Fed would have to either tolerate significantly higher inflation for a period, or tighten its policy in the face of still-significant weakness in the economy and markets.
The Fed’s task was made no easier when Treasury Secretary Tim Geithner unveiled the details of his bank-rescue plan — the Public Private Investment Program — which makes the Fed a major supplier of financing to support purchases of toxic assets that are now clogging the banking system. Excluding this program, the Fed’s own rescue plans could force its balance sheet to balloon to near $4 trillion over the next several months, up from less than $1 trillion last September. Including the Treasury program, another $2 trillion could be added to the total.
Some of this liquidity could be offset through a program whereby the Treasury issues debt and deposits the proceeds with the Fed. That would serve to drain funds from the system, partly sterilizing the Fed’s asset acquisitions. But the Treasury’s capacity to issue debt to fund this program may be limited. The first sign of resistance to the massive borrowing requirements being borne by the federal government came at a recent auction of five-year notes: Demand for the debt was less than expected. So it’s questionable whether the Treasury will essentially want to compete against itself by floating a large amount of additional debt to fund the Fed.
And even if that Treasury assistance goes through, it would account for a relatively small part of the total liquidity that has been added to the system through the Fed’s acquisition of assets.
The Fed is now proceeding on the explicit assumption that once the crisis fades and the economy enters recovery, it can unwind its balance sheet quickly enough to avoid a significant breakout of inflation. But that assumption may rely on faulty premises.
For one thing, the Fed is aggressively expanding a program that provides loans with three-year terms. Unless there is some way of sterilizing the impact of those loans, it will be impossible for the Fed to withdraw that liquidity until the loans come due. At the same time, the Fed is acquiring mortgage-backed securities, assets that may prove difficult to unload at a later date.
There’s also a larger issue at stake: Will the Fed actually know when it’s the right time to unwind its balance sheet? And since it has gone to unprecedented lengths in carrying out its extraordinary monetary ease, how easily and quickly will it be able to shift from an anti-deflationary to an anti-inflationary mindset? When that choice arrives, the Fed may opt for what it considers the least risky solution: tolerating a higher-inflation environment in the interest of market and economic stability.
On that score, a surprisingly honest acknowledgement of the potential quandary facing the central bank came last month from Jeffrey Lacker, president of the Richmond Fed. Lacker told a group at the College of Charleston that the potential inflationary impact of the Fed’s actions “depends on our skill at the Federal Reserve in withdrawing the stimulus in a timely way. That is a very delicate, very hard policy.”
Lacker referred to the “spotty” nature of an economy in recovery, and asked, “Do we keep policy easy and stimulative because of the sectors that are lagging behind . . . or do we get ahead of the curve? It’s going to be a tough call.”
Lacker has strong anti-inflation credentials. So to hear him describe the Fed’s looming choice as a “tough call” seems to raise the probability that the Fed will accede to an inflationary — and unnerving — outcome.