In a National Review post on the recent Producer Price Index numbers, I argued that inflation worries are overwrought — for now. If inflation does become a problem, though, the Fed could have trouble controlling it. Here’s why.

According to a recent AP story, “Federal Reserve Chairman Ben Bernanke told an audience at the National Press Club on Wednesday that … once the economy begins to rebound and financial markets stabilize, the Fed will be able to quickly reverse the actions it has taken before inflation becomes a problem.”

That’s the trillion dollar question.

Federal Reserve bank credit rose from $890.4 billion on September 10 to $1.83 trillion by February 11, mainly because the Fed purchased a lot of semi-toxic securities (e.g., from Bear Stearns) and made huge loans against other dodgy assets. That allowed a similar doubling of the monetary base (bank reserves and currency). Even before that happened, the Fed was selling off Treasuries to make room for lesser investments. The Fed’s holding of government securities has fallen from $790.5 billion in September 2007 to $470.7 billion on February 11 (not counting some second-rate IOUs from Fannie Mae and Freddie Mac).

To assume, as Bernanke does, that inflation cannot possibly accelerate until “the economy begins to rebound and financial markets stabilize” is to assume stagflation is impossible, though 1973–75 and 1979–82 proved otherwise. If inflation catches the Fed by surprise, are they really “able to quickly reverse the actions,” as Bernanke says? How could they do that?

The Fed could certainly raise the interest rates on bank reserves — the fed funds and discount rate — which is how it makes money and credit tighter in normal times. But that rationing device would not prove so effective in times like these, because banks are already sitting on a mountain of untapped reserves. Besides, once expected inflation has begun to rise, the Fed has usually moved rates up in tiny 25-basis point steps — increases so small that perceived real interest rates can continue to fall even as nominal rates rise.

To literally reverse the actions that doubled its assets since last September, the Fed would have to sell nearly a trillion dollars worth of IOUs. Unfortunately, they don’t have nearly that many Treasury securities to sell. And even if the Fed were willing sell off all of its Treasury bills and bonds, the remaining backing for Federal Reserve notes would be little better than junk bonds. Meanwhile, private and agency securities acquired since last September must be very hard to sell — or else the Fed would not have felt obliged to buy them.

The Fed’s System Open Market Account at the Federal Reserve Bank of New York holds $39.4 billion in inflation-protected Treasury bonds — more than twice its $18.4 billion stash of short-term Treasury bills. Are they trying to tell us something?