Will the U.S. become: Inflation Nation?

The most recent economic forecasts, while not suggesting a robust turnaround for the economy, are forming a consensus: the period of contraction may be ending sometime this summer. In his own words, Bernanke's challenge now is “how to wind down the federal balance sheet and avoid inflation.”

 
 

Last week, Federal Reserve Chairman Ben Bernanke told a group of banking regulators in Chicago one of the biggest challenges for the central bank is to develop an exit strategy once the U.S Economy begins to rebound. Specifically, Mr. Bernanke was referring to the $2 Trillion the Fed has put into the financial system since the financial crisis began last year (see table). Bernanke stated the Federal Reserve is examining “how to wind down the federal balance sheet and avoid inflation.”

The most recent economic forecasts, while not suggesting a robust turnaround for the economy, are forming a consensus: the period of contraction may be ending sometime this summer. What Mr. Bernanke is trying to avoid, based on his remarks last week, is having the liquidity that has been injected into system to date manifest in the form of inflation.

Expansion of Money Supply Dollar Amount
Federal Reserve (Troubled Asset) $1 Trillion
Economic Stimulus $789 billion
Freddie Mac & Fannie Mae $280 billion
2008 Budget Earmarks $200 billion
TARP (2009) $350 billion
Tax Rebates (2008) $160 billion
TARP (2008) $350 billion
TOTAL $3.12 Trillion

(Amount includes Federal Reserve and US Treasury)

This is a difficult task for any central bank - wait too long to remove the liquidity from the system (tighten) and run the risk of double-digit inflation; act too soon, and run the risk of stifling a recovery before it has had a chance to take hold. Factoring into the equation the prevailing political winds and the calculus becomes that much more complicated.

The bond markets appear to be weighing in on the consequences of the financial stimulus that has been pumped into the system – treasuries have recently suffered their biggest losses since 1994. Recovering financial markets and a stabilizing economy generally translate into higher interest rates. There is a school of thought that the “slack” in the economy, as evidenced by the employment gap and underutilization in capacity, will keep any inflationary pressures on the back burner – for now.

One lesson we have learned in the past: when it comes time to wean the economy off government support, the tools most often used result in significantly higher interest rates. Credit unions should consider the long-term impact of the decisions they make today in their investment portfolios and ALM strategies, against the backdrop of a inflation fighting Fed.

 

 

 

 

May 11, 2009


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