Fisher Investments Editorial Staff

Reversing the Stimulus

By, 06/29/2009

Story Highlights:

  • Concerns about the Fed's ability to withdraw liquidity from the financial system have many investors concerned about future inflation.
  •  Many point to rising Treasury yields as evidence higher prices for consumers are afoot.
  • Most of the money the Fed has supplied to the financial system is short term by nature, so withdrawing those funds won't be as difficult as most fear.
  •  Already, the Fed is paring back some its programs as credit markets show signs of thawing.


As a global economic recovery seems increasingly in the fore, a new worry is bubbling up—what happens when that wall of global monetary stimulus gets reversed? "Exit strategy" talk is already blamed for recently rising government bond yields—though it's a bit odd, since they remain historically low. But regardless, once the economy staggers back to its feet, a tsunami of liquidity can aggravate inflation if monetary stimulus is reversed too slowly. But if it's reversed too quickly, recovery stalls.

Though the world's central bankers have vastly more tools and experience than they did even a decade or two ago, monetary policy still isn't surgical. So how do we deal with all that liquidity sloshing around the world?  And it's a lot—just in America, the Fed's balance sheet grew by $1.2 trillion in the last 18 months.

But keep in mind, the Fed didn't pump that out there for kicks—they were actively trying to compensate for frozen credit markets. Hobbled credit markets combined with low capacity utilization, rising unemployment, and a generally weak economy means inflation isn't likely to take root any time soon.  But once the economy is on surer footing, the time will come to withdraw the funds or risk higher prices. Many skeptics fear the Fed isn't up to the task.

But will it be such a Herculean undertaking? Recall, many of the recent Fed initiatives are designed not to last long. Programs like the Term Auction Facility (TAF) and Commercial Paper Funding Facility (CPFF) provide firms with short-term capital. When the economy improves and the programs are no longer needed, the loans supplied by the Fed are repaid and the programs end. Even the Treasuries the Fed purchased directly are highly liquid—they can be sold, removing that liquidity with little effort.

The interbank lending market is signaling much improved prospects for banks. The cost of 3-month US dollar loans in the London interbank market dropped to a record low 0.60%, down dramatically from a peak of nearly 5% during last year's financial panic. The Fed sees improvement too and has already begun paring back a number of their facilities—a sign that they see the system correcting, and that there's dwindling demand from healthier institutions.

With the economy still slow and credit tight, the Fed is right to keep liquidity flowing. Worries they won't be able to act quickly enough wrongly assume the withdrawal of liquidity has to be precise and focus on a hypothetical future concern that seems increasingly unlikely to unfold.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.


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