Unwinding

During the recession the Fed has bought about $1.5 trillion dollars in assets that include mortgage backed securities, debt issued by the housing agencies Fannie Mae and Freddie Mac, long-term government debt, and a host of other risky assets. In the process it has created the same amount of bank reserves, most of which sit in the banks' deposits at the Fed because banks are reluctant to make loans. In essence, the Fed has become the primary lender to the US housing market and some other financial markets.

Over the coming year banks will, it is to be hoped, become less reluctant to lend. Those idle reserves will be lent out, the money supply will expand, and the Fed will face the problem of how to "unwind" these extraordinary actions to head off inflation. The NY Times is misleading, however, when it says "Ben S. Bernanke ... now faces the delicate task of beginning to pull the central bank out of its extraordinary effort to prop up the economy." Now is certainly the time to plan, but it is far too early to do.

One thing the Fed certainly should be in no hurry to do is to reduce its holdings of securities (in central bank jargon, to reduce the size of its balance sheet). I think there is a certain level of discomfort, if not at the Fed than among commenators in the press, with the idea that the Fed would be the owner of so many different types of privately issued securities. But the fact that the Fed holds, say, $970 billion of mortgage-backed securities, is not in itself inflationary. Inflation will be a danger when idle reserves are turned into loans and therefore bank deposits (money). The Fed can control the pace of new lending by adjusting the interest it pays on reserves. It does not have to adjust its holdings of securities.

It would be a terrible mistake for the Fed to sell off its security holdings prematurely. Doing so would cause interest rates on these types of lending to rise and cause the recovery to stall. The Fed knows this, and so will not make this mistake. Securities should be sold off only as quickly as private sector demand for them increases. This could be a long process.