March 9, 2009 / 9:22 PM / 10 years ago

UPDATE 1-Inflation risk in Fed's monetary boost -Fed study

(Adds comment by study author, byline)

By Alister Bull

WASHINGTON, March 9 (Reuters) - 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 bank.

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 economy.

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 Adler)

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