There can be little doubt about the long-run inflationary threat to the US economy posed by the very large excess bank reserves created by the Federal Reserve. However, it is far from clear how imminent that inflation threat might be and how quickly the Federal Reserve should begin exiting from the extraordinary monetary policy loosening of the past year.

            There are several good reasons to believe that inflation is not an immediate risk to the US economy and that the Federal Reserve would be ill-advised to prematurely exit from its easing policy. First, one would think that the very large gaps presently characterizing the US labor and output markets will continue to exert downward pressure on wages and prices. Wage incomes are already increasing at their slowest pace in the past fifty years, while core consumer price inflation has been trending downwards.

Second, it would seem more than likely that any recovery from the present economic recession will be unusually weak, which will only further increase the size of those labor and output market gaps in 2010. In particular, one must expect household consumption, which accounts for 70 percent of US aggregate demand, to be severely constrained both by subdued wage income growth and by attempts by households to increase savings as a response to the decline in their wealth. And without meaningful consumption growth, it is difficult to see how one gets a robust and sustainable economic recovery

            Third, one would think that banks are very unlikely to draw down their excess reserves at the Federal Reserve until they have repaired their own balance sheets and until households and corporations increase their loan demand. With unemployment likely to soon exceed the worst case scenario under the Treasury’s bank stress test and with commercial property prices now in free fall, one would think that banks will continue to horde liquidity in anticipation of further loan losses.

            These considerations would suggest that the Federal Reserve has ample time to begin exiting from its policy loosening. It would also suggest that the Fed should be mindful of the very real risk of aborting the present incipient recovery by prematurely tightening monetary policy at a time when households and corporations are still in the process of balance sheet de-leveraging.   

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There are two parts to the answer to this question. Mechanically, the Fed can manage the process of reducing its balance sheet through a combination of lowering interest payments on reserves and selling assets. So in a mechanical sense the answer to the question is clearly yes. But politically and economically this could prove difficult. Economically, there will be costs to selling some securities and incurring capital losses (that is, on the ones the Fed has been propping up by buying), and the Fed may not want to incur large capital losses for political reasons. More broadly, given the huge and expanding deficit, the Fed will come under increasing political pressure to permit inflation to rise, and this is a more likely outcome in a Fed that has seen a substantial deterioration in its independence as the result of its participation in credit support and bailout policies and the related political battles those have entailed. Even worse, the anti-growth policies of the Obama Administration (high tax rates, new taxes, growth in government spending, retreats from free trade) will increase the inflationary pressure, as anti-growth policies did in the 1970s. That is perhaps the most worrying potential economic and political influence on inflation, which I believe will limit the Fed's willingness to bring its balance sheet down in size as quickly as it should. The likely consequence is a rising trend in inflation over the next five years.

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This is an excerpt from the current edition of Fortune.

Federal Reserve Board Chairman Bernanke has gone to great lengths to affirm that he has a workable “exit strategy” from the Fed’s extraordinary actions and involvements of the past year or so. It is fair to say that he is thoroughly convinced, and so far the markets appear to be giving him every benefit of the doubt. And why not? So far, they have no reason to doubt his intentions. But the exit strategy involves a great many unknowns. And a misstep could be very painful.

If the exit strategy works as advertised, the Fed will be able to whittle away at the mountain of excess reserves in a steady, controlled fashion, feeding liquidity to credit markets without triggering unwelcome inflationary pressures. Paying interest on reserves is a vital new tool in this strategy.

But what if it doesn’t work? What if there turn out to be practical limitations to the Fed raising the interest rate it pays on excess reserves. This is uncharted territory where the only near certainty is that there will be surprises. If the Fed can’t keep those excess reserves under control, it would likely have to raise the Funds rate faster and higher than it would prefer, threatening the recovery or, quite likely, triggering yet another recession.

So far, banks appear content to keep vast reserves at the Fed, earning a modest return. As the recovery takes hold and the interest rate structure starts to rise, the rate the Fed pays will have to rise, as well. In theory, the increase in the rate paid on reserves should work, and as it does inflation expectations should remain contained. Given the events since the collapse of Bear Stearns, one “in theory” and two “shoulds” is asking for a lot of faith.

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