As Ben Bernanke attempts to articulate an 'exit strategy' from the recent unprecedented policy actions, it's worth revisiting the precise nature of these actions as the Fed balance sheet balloons to 14% of US GDP. There is considerable confusion apparent in media commentary on how exactly the Fed has expanded its balance sheet and its potential inflationary implications. The power of any central bank derives from its ability to create money, which it can use to acquire assets or extend loans. The Fed's actions can be analyzed in terms of the asset side of its balance sheet (the assets and loans it holds), or the liabilities side (the money or other obligations it has created); until January of 2008, by far the most important assets held by the Fed were short-term Treasury bills. Through 2008, the Fed significantly expanded its loans in the form of currency swaps with foreign central banks, lending to U.S. banks through term auction credit, and the Commercial Paper Lending Facility. Combined, these actions more than doubled the assets of the Fed by the end of the year, despite the fact that the Fed sold off 40% of its original T-bills.

A huge volume of the deposits that the Fed created are still just sitting on the banks' books (hence the low velocity of money in the US economy currently). Commercial banks are happy to park their cash partly because the overnight lending opportunities are not particularly attractive at this stage, and also because the Fed now pays interest on those reserves. From the bank's point of view, funds left on deposit with the Fed at the end of the day aren't idle at all, under the new system adopted in the fall of 2008. In fact, the Fed could potentially use this device to prevent much of its asset side activity from showing up as an increase in currency held by the public, simply by raising the interest rate the Fed offers to pay on reserves to whatever level is necessary to persuade banks to continue to hold these funds idle overnight in a novel form of monetary 'fine tuning'. In effect, the Fed is through this device borrowing directly from the public to fund its asset-side activities rather than by "printing money" in commonly understood quantitative easing terms. Overall, as can be seen in the chart below, as the US private financial sector has 'de-risked' by dumping the most difficult to value derivative securities, the Fed has absorbed much of that toxic paper and transformed the quality of its own balance sheet so that 75% is now comprised of risk assets of varying but generally poor quality.

The Fed also asked the Treasury to borrow money through public auctions; banks paid for these new T-bills by instructing the Fed to transfer to the Treasury the Federal Reserve deposits that they'd received from the Fed as a result of the various bailout programs. The Treasury then just left the funds sitting there in its accounts with the Fed. In effect, the Fed obtained the funds for some of its actions on the asset side not by "printing money" as commonly assumed but instead by having the Treasury borrow funds on its behalf on the liabilities side. Does this analysis allay inflationary concerns people may have about the doubling in the size of the Fed's balance sheet? 

It is true that the new assets have not yet shown up as an increase in the money supply, and it is true that the Fed has the power to prevent them from doing so in the future. The real issue is that the medium-term fiscal deficit trend is fundamentally inconsistent with the Federal Reserve choosing to keep inflation under control. Both the ballooning of the Treasury's account with the Fed and enabling the Fed in effect to borrow directly on its own, are indeed as much fiscal measures as they are monetary. But to anyone worried about the growing confusion of monetary and fiscal policy as the Fed grows all-powerful (and with very limited oversight), that blurring of the lines is dangerous.

Eventually, we may well face a crisis of confidence in the Treasury and the dollar itself, because as I've explained before, the scale of aggregate US leverage at almost 400% of GDP is now so daunting that no conceivable growth outcome can offer an orderly exit. Ben Bernanke has suggested that raising the interest rate paid on reserves would be a policy tool that could be used in response to inflation risks as bank lending recovered. But it would be an unattractive measure to the extent of perhaps being impossible to use in practice, for the same reason other countries have avoided raising interest rates in the face of collapsing real economic activity and a flight from their currency when monetary policy gets politicized.

Is the US government mistakenly assuming that it can borrow essentially unlimited sums without undermining confidence in the dollar itself? A successful 'exit strategy' involves extricating the US taxpayer from the huge combined fiscal commitments currently assumed by the Treasury, the Fed, the FDIC, the Medicare and Social Security trust funds, and various and sundry implicit and explicit federal guarantees. On that analysis, however painful 10% unemployment may be, a further stimulus plan or expanssion of the Fed balance sheet (eg via the TALF to absorb commercial real-estate MBS) as now widely mooted may be the straw that breaks the back of foreign investor confidence and helps reverse the current risk rally later in the year.