(Adds comment by study author, byline)
By Alister Bull
WASHINGTON, March 9 The Federal Reserve is
risking inflation after doubling the size of the U.S. monetary
base and will face tough choices if prices start to rise before
a recovery begins, according to a study by a regional Fed
The U.S. central bank has massively boosted the monetary
base, which includes currency in circulation and bank deposits
held at the Fed, in an effort to support markets during the
most severe financial crisis since the Great Depression.
"Inflation does not appear to be a risk in the current
environment: the economy is in recession. Inflation is falling
and is not expected to return before the recession ends,"
according to an essay in the March/April edition of Review
magazine, published by the Federal Reserve Bank of St. Louis.
"If inflation resumes but the economy does not recover,
policy-makers will face a difficult choice. Monitoring the size
and composition of the monetary base will help us understand
what actions are needed," the study said.
Emergency measures to flood credit markets with cash to
stop them freezing in panic over bank losses doubled the size
of the Fed's balance sheet and boosted the monetary base to
around $1.7 trillion.
Fed officials agree they need an exit strategy to soak this
money back up once the recession ends. They don't think it is
an inflation risk right now because banks are still too scared
to lend the extra money out in a way that would boost the
broader money supply and lead to higher prices.
In the meantime, they must save the economy from an even
more severe downturn, and argue that programs used to boost
credit markets can be allowed to expire as the recession ends.
Critics warn it will be politically very hard to pull the
plug on some of these support measures if financial markets
remain under strain, possibly forcing the Fed to water down its
commitment to keep prices low and stable while supporting the
Billionaire investor Warren Buffett on Monday praised the
efforts of the Fed to stimulate the economy but cautioned the
measures could lead to an inflationary cycle worse than the one
that followed the 1970s oil shock.
"We are certainly doing things that could lead to a lot of
inflation," he said. "In economics there is no free lunch." For
details, see [ID:nN09351566]
The St. Louis Fed study airs these concerns, without
explicitly siding with those who fear the Fed has painted
itself into a position that will be hard to escape with its
anti-inflation credentials intact.
"Whether this large increase in the monetary base is a
harbinger of rapid inflation in the future depends on how the
Federal Reserve and the U.S. government act when financial
markets return to more normal behavior," the study said.
Study author William Gavin said the ability of the Fed to
suck back the money could amount to persuading the government
to take over the credit programs.
But he said this would put the decision into the hands of
the Congress, because it would increase the U.S. deficit and
would hence be a political decision.
"If it becomes difficult for us to shrink the monetary
base, we will need the help of the Congress," he said.
(Reporting by Alister Bull; Editing by Tom Hals and Leslie