In a commentary published today on the Fed's exit strategy, I write that tightening will be much harder to pull off than Fed officials think:
"Unwinding its current monetary policy is a difficult maneuver: tighten too fast, and the Fed could risk setting off a much dreaded double-dip recession; tighten too slow, and high inflation could result."
The dramatic measures taken by the Fed in response to the financial crisis has swollen its balance sheet with large amounts of toxic debt, at the same time injecting huge amounts of liquidity into the banking sector. So far this newly created money has not led to an expansion of credit or a rise in prices, as banks have been reluctant to lend. But once lending picks up again, the unprecedented amount of bank reserves acccumulated during the crisis creates a potential for rapid inflation. This is why the Fed needs and exit strategy:
"In order to avoid a second “Great Inflation” like the one in the 1970s, the Fed relies upon its newly designed and untried strategy of adjusting the interest rate on bank reserves upward, which according to Fed officials will “limit the demand for credit.” The rate is currently 0.25 %. How high this rate has to go in order for the Fed’s plan to actually work, no one knows yet.
There are several problems with this “exit strategy,” not the least of which is the overconfidence on the part of Bernanke and his colleagues that they will get it right. Over-confidence, both among Federal Reserve officials and financial market actors in the years leading up the crisis, based on the belief that the Fed would always be able to come to the rescue and do the right thing, was one of the things that got us into this mess in the first place.
There is a certain hubris to all this: Even if Fed officials have the right tools, how would they know exactly how to exit in which timely fashion? And how would they know which interest rate would be right?"
Read the rest of the commentary here.