Federal Reserve's Next Test: Reeling In Lifelines

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By Annys Shin
Washington Post Staff Writer
Tuesday, May 26, 2009

As if the worst recession since World War II, the near collapse of the financial system, and the prospect of double-digit unemployment weren't enough to deal with, the Federal Reserve now has something else to worry about: success.

Lately, a steady stream of economic data has suggested that while the economy is still shrinking, the pace of the decline is slowing. That, in turn, has stoked fears that the Fed's efforts to steer the economy away from a 1930s-era depression would push the country toward '70s-style inflation.

Those fears center on the Fed's unprecedented efforts to revive the economy by creating more than $1 trillion in new money. Determining the best time to withdraw that money is a classic quandary for central bankers. The challenge of timing is even more daunting than usual this time because the Fed has become so integral to shoring up the financial system. As Fed leaders ponder their next move, analysts say they may have to choose between propping up credit markets today and fighting inflation tomorrow.

It typically takes at least six months before the Fed's decisive policy shifts translate into economic activity. So if the Fed wants to forestall inflation from getting out of its ideal range of around 2 percent, it will probably have to act while unemployment remains high and before the financial sector is completely healed.

Fed Chairman Ben S. Bernanke has used recent public appearances, including one before the congressional Joint Economic Committee, to offer reassurances that the central bank was "focused like a laser beam" on the tricky question of how and when to pull out of credit markets.

"We're working very hard, and it is important for us to provide a lot of support right now. The economy needs support," Bernanke told lawmakers. "We understand the necessity of winding this down at the proper moment so we will not have an inflation problem at the other side."

By problem, he means rising prices that destroy the value of money -- an experience fresh in the public memory. During last summer's run-up in gas prices, real disposable income fell at an annualized rate of 8.5 percent from July to September, Commerce Department data show.

An increase in energy prices is one of several contributors to rising inflation. Another is when demand outstrips supply and when there's too much money in circulation.

Fed officials say the risk of inflation is low because much of the money the Fed has created is not circulating but sitting in bank reserves. But because those reserves are so large, other economists see potential for danger. If the Fed moves too slowly once the economy recovers, that money could get out quickly. As a result, some view signs that the recession is starting to ease as meaning that it is time to step back by ending some of the Fed's emergency lending programs.

"There's things they can start now," said Stanford University economist John Taylor. "They should look at the ones that they would say are working least well and start pulling those back."

The Fed has already been criticized for keeping interest rates too low for too long after the 2001 recession and helping fuel the housing bubble that subsequently burst, taking the economy down with it.

"People look back now and say they overdid it; they should have raised rates earlier," Massachusetts Institute of Technology economist Simon Johnson said. "This is kind of a rerun. [They] could make mistakes on both sides."


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