Potential Problems Reeling in Future Inflation

It is important to be well aware of the sticky situation the Federal Reserve has gotten in concerning the risk of future inflation.  Normally in a period of expanding economic activity the Fed reigns in the money supply by selling Treasuries on the open market and waiting for the short term market to respond with interest rate rise.  This strategy works well when the initial money placed in the economy is through the Fed buying US Treasuries from banks.  The Federal Reserve has built a reputation by accurate targeting of the overnight (Fed Funds Rate) money market using this method. 

However, in 2010, more than half of Federal Reserves balances are comprised of non-treasury securities.  These cannot be easily sold back on the open market to reign in inflation.  The open market for Mortgage Backed Securities (MBS) is only beginning to return and the Fed selling their share of MBS in large quantities would likely cause mortgage rates to soar and another housing crisis.  In essence, the Fed has one hand tied behind its back when dealing with inflation because they can only soak up a portion of the money they placed in to the economy in the past few years. 

And Ben Bernanke is well aware of this situation.  This is why he has proposed three different methods of draining excess money from the economy besides the usual means of selling treasuries.  One method would be to raise the interest rate paid on excess reserves held by banks at the Federal Reserve.  The other two methods are offering reverse repurchase agreements and term deposits to banks, which would essentially incentivize banks from lending for periods of time controlled by the Fed. 

These alternative approaches should all have a similar end effect as the Fed selling treasuries but have not been tested on a large scale as a way of moving short term money markets in the U.S.  This leaves some reasonable grounds for concern about the Federal Reserve’s future ability to tame inflation in the next five years.  With unprecedented monetary injection, the stakes are high.  We will have to stay tuned to see if these new methods will work as intended.