Experts fear money deluge from Fed will spur inflation

The Federal Reserve has long been a black box, mysterious in its workings to many economists and little more than a vaguely powerful presence to most Americans.

Since September, under Chairman Ben S. Bernanke, the U.S. central bank has exploded in size by taking on massive amounts of risk from the private sector in a frenetic effort to prevent a greater financial meltdown.

The size of the bank, measured by credit supplied to financial institutions, accelerated from $890 billion in September just before the failure of Lehman Bros. Holdings Inc. to a peak of $2.24 trillion in December before falling back last week to $1.91 trillion.

In simple terms, the Fed created a flood of money - though not the kind you could easily spend at your corner store - out of thin air.

Bernanke offered assurances in a speech last week that the bank was not taking too much risk and that, once the economy turned around, it could nip in the bud any dangerous outbreak in inflation caused by the deluge of money.

But experts are wary.

"It may get out of control. I don't think we've had nearly enough discussion of that in the public sphere," said Franklin Allen, a professor of finance and economics at the University of Pennsylvania's Wharton School.

The decline in the Fed's balance sheet since December - much of it because the slumping global economy means foreign central banks have less demand for U.S. dollars and because of improvement in the market for short-term corporate debt - may be short-lived.

The bank's policy-setting Federal Open Market Committee recently set a target of buying $100 billion in debt issued by the nationalized mortgage-finance companies Fannie Mae and Freddie Mac and $500 billion of mortgage-backed securities by the end of June.

Furthermore, the deepening problems at Citigroup Inc. and Bank of America Corp., whose shares plummeted last week on fears of a government takeover, could make the Fed an even bigger player among commercial banks.

When the Fed purchases something, it does not have to borrow money as the U.S. Treasury Department does. Instead, when the central bank buys, for example, a mortgage-backed security from a financial institution, it pays for it by adding the same amount of money to an account the financial institution (or its bank) has at the Fed.

"That's essentially printing money," said Robert A. Eisenbeis, a former Federal Reserve economist and now chief monetary economist for Cumberland Advisors Inc., an investment manager in Vineland, N.J.

The Fed's efforts have at least two objectives: reducing overall interest rates and reducing interest-rate spreads. Spreads are the differences between the interest rates paid by low-risk borrowers, such as the U.S. government, and high-risk borrowers, such as troubled companies.

Based on those measures, Bernanke has succeeded, Eisenbeis said, "but you have to ask yourself whether it's worth it to incur the risks . . . we're incurring to lower spreads by 100 basis points."

Chief among those risks is a dangerous spike in inflation once the economy turns around, because the financial system has been flooded with so much money.

Observers said Bernanke and other Fed officials were properly focused on the greater near-term specter of a deflationary spiral. In that worst-case economic scenario, prices fall, output declines, and debt suffocates the economy because borrowers have to repay with dollars that are more valuable than those they borrowed.

The Fed is walking a tightrope, like famed high-wire performer "Karl Walenda in a gale," said Arthur D. Cashin Jr., managing director of floor operations for UBS Financial Services Inc.

Right now, inflation is not a threat because the economy is in the tank. It is as if the Fed dropped a huge amount of money from a helicopter, but instead of spending the money, everybody takes it inside and stuffs it in a mattress, Cashin said.

Bernanke said Wednesday that the Fed's lending programs were structured in a way that would undermine an inflationary outbreak and that the bank would be able to act quickly to pull back on credit.

That is what central bankers always say about inflation, according to Cashin. They think they "can catch it in full flight. That rarely, if ever, happens," because political pressure always makes it difficult to raise interest rates and pull back on lending programs until it is too late, he said.

Inflation is not the only risk in the Fed's unprecedented actions.

Allen, the Wharton professor, said the Fed was also bearing a lot of credit risk because it was accepting low-quality securities as collateral for its loans that create money out of thin air.

"Essentially, they are bearing all the risk in the economy if they keep doing that," Allen said. "In my view, that is not good."

In his speech last week, Bernanke said that the short-term nature of most of its lending protected it from risk and that Treasury would stand behind the debt and other securities issued by Fannie Mae and Freddie Mac.

Who stands behind the Treasury? Taxpayers.

Experts agree that the Fed must act to fix the financial system, but the effort is fraught with uncertainty.

"It's not so clear this is the best way to do it," Allen said. "Maybe it is."