I think that the Fed is very capable of taking back the added liquidity

TO BE NOTED: From News N Economics:

"Some random thoughts on inflation (deflation)

Wednesday, April 1, 2009

I was in Mexico for one week and the only news-related materials I had were two March issues of the Economist; and fortunately, this is poolside reading for me. Anyway, the March 19th edition had a nice article about quantitative easing and the associated inflation angst and featured this chart to the left. The article inspired me to think a little more about why the Fed is taking such extreme balance sheet risk: inflation.

Recently, the Federal Open Market Committee shocked markets by announcing its intent to buy Treasuries in excess of the nominal 0.25% federal funds target, and to increase the MBS and agency coupon purchases by $850 billion. In spite of a 0.2% annual inflation rate in February, recent Fed policies like these have sparked fears of inflation, even hyperinflation. From the Economist:

On March 18th America’s inflation rate was reported at 0.2%, year on year, in February. The same day the Fed said “inflation could persist for a time” at uncomfortably low levels. Yet some economists and investors insist high inflation, even hyperinflation, is lurking in the wings. They have two sources of concern. The first is motive: the world is deleveraging, ie, trying to reduce the ratio of its debts to income. Policymakers might secretly prefer to do that through higher inflation, which lifts nominal incomes, than through the painful processes of cutting spending and retiring debt, or default. The second is captured by the Fed’s announcement that it plans to purchase $300 billion in Treasury bonds and an additional $850 billion of mortgage-related debt, bringing such purchases to $1.75 trillion in total, all paid for by printing money. The Fed is doing what it is doing - quantitative easing - in an attempt to restore functionality to credit markets and to accommodate a low and falling money multiplier in order to secure price stability. Banks are hoarding funds (excess reserve balances one year ago were $1.8 billion and $771.2 billion now), which has been exacerbated by the Fed's paying interest on reserves, but nevertheless, reserves are surging. The result has been a collapse in the money multiplier, which disrupts the process by which the Fed's monetary policy measures (adding base to the system) are turned into money.

The chart above shows that the money multiplier has stabilized, but rests at very low levels. This is the bear faced by the Fed, and the primary reason for its extreme measures of late.

But contemporaneously, inflation expectations have taken a likewise turn for the worse. As falling inflation expectations become embedded into current behaviors (buying decisions or interest rate setting), the macroeconomy suffers. When oil was peaking in July of last year, the Fed watched inflation expectations closely for signs of pressure. And now, the Fed is watching those same expectations on the way down.

The chart illustrates market inflation expectations for each year over the next 10 years, as measured by the nominal 10-yr Treasury minus its inflation protected counterpart (TIPS). Admittedly, inflation expectations have improved significantly from their 0.04% low in November 2008 to 1.34% at the end of March. However, the market still expects just 1.34% annual inflation over the next 10 years, which is far below the Fed's new quasi inflation target of 1.7%-2.0%, and obviously a big concern.

This is why the Fed and central banks around the world are building up their balance sheets: inflation (deflation) risk. In the U.S. and according to the Taylor Rule, a nominal interest rate target based on current inflation, inflation expectations, and the output gap, the Fed should cut the federal funds target, the Fed's short-term interest rate to induce monetary stimulus, to -8%. Since that is impossible (a zero lower bound), the Fed is doing everything it can to support price stability.

I think that the Fed is very capable of taking back the added liquidity; and furthermore, I presume that the paying interest on reserve balances is part of the Fed's exit strategy. However, we will know in a year or two if the Fed gets it right. But know this: a $2 trillion balance sheet is just the beginning.

Rebecca Wilder"