When the Fed more than doubled its balance sheet during the financial crisis, many believed inflation was unavoidable. Since then, the dollar has fallen 15% and gold, other commodities, and commodity-linked currencies have soared. But the inflation expectations that moved markets throughout 2009 were never justified by data, with economic data indicating deflation was the real concern.
The inflation expectations of 2009 were essentially theoretical. It is commonly taught in every basic economics or business school that the US money supply is a function of the amount of credit available in the economy. Since theory teaches us that, through the money multiplier, a small increase in reserves leads to a dramatic increase in lending, the common conclusion was that the ballooning of the Fed's balance sheet meant that the money supply would increase dramatically, thus causing inflation. Of course, in actuality, this was impossible since commercial banks had to hold all their reserves to offset coming losses. Lets not forget this is still the case in banking today. Commercial banks are still bracing for losses. In the US, the big scare is CRE. In Europe, it's sovereign debt.
The issue for the Fed was that even though inflation itself was unlikely, simply inflation expectations by themselves were damaging the US economy. While a falling US dollar is good for industry, it is not good for the US financial system. Inflation expectations were having an especially deleterious effect on fixed-income markets which was hurting US financial system as a whole. Companies were having to pay more for dollar-denominated debt. US treasury yields rose increasing the government's interest. Overall, the prospect of a declining dollar was negative for the global financial system.
Inflation expectations put the Fed in a tough position. The Fed must create the "illusion" of an exit without actually exiting, because the economy still requires extraordinary support. But the Fed can't easily "fake it." The most apparent option, to start selling assets and decreasing its balance sheet, is unfeasible because it would cause havoc in the economy. (Long-term interest (especially mortgage) rates would surge, housing prices would collapse, and banks would begin a new wave of write-downs.) No, this problem requires a creative solution.
When the Fed first realized it had to do something to address mounting inflation expectations, it started a PR campaign as never seen before in the history of the Federal Reserve. A little less than a year ago, Ben Bernanke went on 60 Minutes and stated that the Fed is planning on exiting its MBS buying program. This simple move made a big difference. Long-dated treasury yields decreased about 30 basis points as Bernanke assured the market that there would be an end to quantitative easing and the Fed would not monetize any US debt. I think this week was the next leg of the Fed's PR campaign to once and for all destroy inflation expectations.
The Fed's exit will consist not of decreasing its balance sheet but by refinancing the balance sheet with funding that does not qualify for bank liquidity requirements. Funding that does not qualify for liquidity requirements cannot be multiplied 10x to create credit. Though the details themselves aren't that important, the most likely route the Fed will take is reverse-repo loans, where the Fed issues loans and is paid in dollars, which the Fed can retire, because money market mutual funds are well suited to serve as counter-parties.
Remember — Bernanke is the same guy who wanted to raise rates in the summer of 2007. Only when the deleveraging cycle runs its course will the Fed have the temerity to begin to snug up liquidity conditions It was a very eloquent dissertation (not really) and Wall Street research houses spared little ink in its response, but even as Ben Bernanke tried to placate the bond bears and policy hawks, the Fed’s exit strategy, whether it be in interest paid on reserves, widening the discount rate/funds rate spread, or reverse repos, is a concept. It’s not reality. The aim would be to curtail the banking sector’s ability to extend credit at a time when the White House is doing all it can to pressure lenders to open the credit spigots. Not only that, but the data continue to portray an economy in desperate need of the visible hand of the government sector and an economy that is still beset by an ongoing contraction in credit. Only when the deleveraging cycle runs its course — perhaps five years from now if history is a guide — will the Fed have the temerity to begin to snug up liquidity conditions.
