WASHINGTON (Reuters) - The trillions of dollars in public funds U.S. officials are putting on the line to stabilize financial markets and protect the economy from a deep recession would, in normal times, inspire fear of soaring inflation and a tumbling dollar.
But these are not normal times.
“The patient’s on the floor right now. You want to get him up off the floor; then you worry about diet and exercise,” said James Horney of the Center on Budget and Policy Priorities.
With Sunday’s late-night announcement of a $306 billion government backstop for ailing bank Citigroup Inc (C.N), the potential bill for the U.S. financial cleanup has topped an eye-popping $5.7 trillion, although far less has been committed and money extended might not be lost.
The Treasury Department had already secured a $700 billion fund to aid banks and vowed to provide up to $200 billion to prop up mortgage finance companies Fannie Mae and Freddie Mac, while the Federal Reserve had expanded its balance sheet to $2.1 trillion as it pumped funds into frozen credit markets.
More federal largesse in the form of a government spending plan to spur the economy appears on the way.
“We are going to do what what’s required to jolt this economy back into shape,” President-elect Barack Obama said at a news conference on Monday.
In addition, the Fed has cut interest rates to a low 1 percent and some see the U.S. central bank bringing borrowing costs even lower, perhaps all the way to zero, as attention shifts to the possibility, if remote, that the stumbling economy could be headed for a bout of debilitating deflation.
These actions could be recipes for higher interest rates, inflation and a weaker dollar. But analysts say there is reason to believe the government can remove emergency life-support measures before nasty side-effects are seen.
“The market is so afraid of a deflation, Japanese-type story that the budget deficit becomes irrelevant, at least in the here and now,” said Joseph LaVorgna, chief U.S. economist for Deutsche Bank Securities.
“The order of correction is getting the financial markets functioning so that these various initiatives have a much better chance of doing their job, together they self-reinforce, the economy comes out, the stimulus is taken out, the Fed then can lift rates to a more-normal level.”
The deflation fear is one thing U.S. policy-makers have on their side. The huge appetite investors have shown for U.S. debt, which offers relative safety at a time financial markets are undergoing extraordinary turbulence, has kept Washington’s borrowing costs unusually low.
“Treasuries are trading at a huge discount to every other asset on the market, and so that is one reason that there’s not much of a barrier in the near term to borrowing,” said Zach Pandl, an economist for Barclays Capital.
By the same token, the rock bottom interest rates the Fed has put in place would only translate to a resurgence of inflation in any eventual turnaround if the Fed fails to reverse course in time.
“The big problem is, will the Federal Reserve be able to extract itself as the economy recovers?” said David Kotok of money manager Cumberland Advisors.
In early summer as oil prices set record highs, Fed officials were looking at inflation risks warily. However, as the downturn began to bite in recent months, the central bank largely set aside its inflation concerns.
Some Fed policy-makers, however, are urging the central bank not to let its guard down for too long.
“It may seem premature to be worrying about how inflation behaves after the recession is over, but we need to be sure our policy remains consistent with a strategy that does not allow inflation to ratchet up over the business cycle,” Richmond Federal Reserve Bank President Jeffrey Lacker said on Monday.
Reporting by Mark Felsenthal; Editing by Dan Grebler