The Federal Reserve may hike up interest rates to combat inflation as early as the beginning of next year, says Stanford University Professor John Taylor.
Interest rates have hovered at a very low target range of zero to 0.25 percent since December, as monetary policymakers have worked to get the country out of the recession.
Lower lending rates can eventually lead to rising consumer prices.
The government, meanwhile, has earmarked $787 billion in stimulus spending programs that should inflate the country's budget deficit, which can also fuel inflation, Taylor told Bloomberg News.
The Congressional Budget Office predicts the budget deficit will widen to $1.6 trillion this year.
On top of low interest rates, the Federal Reserve balance sheet has ballooned by $1.2 trillion since the monetary authority bailed out organizations such as insurance giant AIG and took on other assets.
“The Fed’s balance sheet has just exploded. They’ve got to find a way to bring it down,” Taylor said.
Now, Obama administration officials say, the financial system is on the mend and it's time for the government to start stepping aside.
"The financial system is showing very important signs of repair," Treasury Secretary Timothy Geithner said.
Markets on the mend do not mean that the overall economy is very close to fully healing, he also cautioned.
"I would not want anyone to be left with the impression that we're not still facing really substantial enormous challenges throughout the U.S. financial system."
Geithner told Congress this week the government will soon roll back support for Wall Street rescue programs, a move that Taylor applauds.
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