The Fed's extraordinary support for the financial system suggests it will have less margin for error to stave off inflation as recovery gathers steam, according to a St. Louis Federal Reserve Bank economist.
The Fed — the U.S. central bank — cut benchmark interest rates to near zero in December 2008 and created emergency lending and purchase programs as it battled the worst recession in more than 70 years.
In so doing it has more than doubled the size of its balance sheet to around $2 trillion, worrying some economists that inflation will result once the economy recovers.
Some of the Fed's special lending facilities are winding down on their own as financial conditions improve, St Louis Fed economist Kevin Kliesen wrote in the regional central bank's quarterly review of business and economic conditions in an article entitled, "Inflation May Be the Next Dragon to Slay."
"Still this process will not be sufficient to prevent a potentially destabilizing surge in money growth, which means that Fed policymakers will have to adopt other, more aggressive strategies."
Fed officials have said options include paying interest on excess reserves and selling some assets on its balance sheet.
"Regardless of the method used, an improving economy means that the Fed must be prepared to raise its interest rate target to prevent an unwanted expansion in money growth by the banking sector," Kliesen wrote.
Fed Chairman Ben Bernanke and other policy-makers are "quite confident" that they have the tools and determination needed to prevent an unwelcome acceleration in inflation and inflation expectations, Kliesen wrote.
"Unlike previous episodes, though, the magnitude of the policy responses to the financial crisis and the Great Recession suggests that the FOMC's margin of error seems much smaller than at any time in the Fed's history," he wrote.
Kliesen noted there is a "considerable amount" of disagreement among economists about the outlook for inflation over the next couple of years.
Some place more emphasis on high unemployment putting a damper on inflation while others believe the risks of higher inflation have increased due to large budget deficits and the Fed's asset purchase programs.
Kliesen suggested disagreement on the inflation outlook could provide some insight into what lies ahead, noting that past five-year forecasts of the average Consumer Price Index inflation rate from Blue Chip Economic Indicators show that when inflation was relatively high and variable, such as the late 1980s and early 1990s, there was sizable disagreement among forecasters about the medium-term inflation outlook.
"By contrast, during periods when inflation tends to be relatively low and stable, such as the mid-1990s to mid-2000s, forecasters tend to disagree less about the ... outlook."
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