The Federal Reserve has embarked on a massively expansionary monetary policy. Since mid‐September, the Fed has more than doubled its balance sheet. No other episode in U.S. history has seen a monetary policy remotely as expansionary as what the Fed has put in place since mid‐September.
Before September, the Fed financed its various bailouts and credit extensions by selling Treasury securities, so that its overall balance sheet remained roughly constant. Since September, the Fed has financed its credit extensions by the electronic equivalent of printing money. Money creation on this massive scale will begin to have highly visible effects in 2009.
The first effect will be to help pull the economy out of the severe recession now gripping the nation. This effect will be highly welcome. Then, when the economy starts to recover, probably sometime in the second half of 2009, the Fed will be faced with the difficult task of pulling money out of the system.
Why will the Fed find the task of reducing its balance sheet so difficult? When the economic recovery begins, the Fed will have to start raising interest rates — perhaps sharply — to scale back its bloated balance sheet. It will be very controversial for the Fed to begin raising its policy rate — the federal funds interest rate. Why should the Fed, people will ask, be raising its policy rate when the economic recovery has barely begun? The answer is simple: The Fed will have to raise interest rates to avoid the inflationary consequences of printing so much money.
So, my forecast is that the real economy — production and employment — will begin to look better in 2009. But it will not be time to exhale in relief. Problems of managing the recovery and avoiding inflation will dominate our attention. Those problems will not be trivial.