Can the Fed wind down its stimulus without hurting the economy?

It's like we're "riding the back of a tiger," says one economist

Winding down the stimulus
(Image credit: Win McNamee/Getty Images)

As the the five-year anniversary of the 2008 financial crisis approaches, the Federal Reserve is toying with the prospect of phasing out its giant monetary stimulus plan, in which the central bank buys $85 billion worth of treasuries and mortgage-backed securities each month in an effort to hold down interest rates and encourage borrowing.

Here's the problem: Every time the Fed mentions the stimulus-slowing possibility, which it calls "tapering," markets go haywire, highlighting how tricky the transition will be. In May, when Fed Chairman Ben Bernanke first floated the idea — with the giant caveat that the economy would need to be in solid shape before tapering began — he set off a short but violent global sell-off.

Pingfan Hong at the World Economic Forum compares the Fed's predicament — it wants to eventually wind down stimulus, but risks a global freak-out by even mentioning it — to "riding the back of a tiger."

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"It would be difficult for the Fed and other central banks to 'dismount' from [monetary stimulus] programs without being devoured," he writes. Hong's message is clear: It's relatively easy to begin a fiscal stimulus program, but it's very painful, if not downright dangerous, to stop.

A related concern: Some analysts see the Fed's intervention as a crutch propping up an injured economy rather than a cure that will inevitably help the patient walk again on his own.

"The massive stimulus efforts by global central banks clearly did not provide a permanent cure for the underlying problems, and more problematic, just maintaining the status quo has required increased dosages of stimulus," says Sy Harding at Forbes.

It's like a patient with serious medical conditions being prescribed oxycodone to relieve the pain while a series of time-consuming procedures are planned to fix the condition. If the procedures don't work out, the patient will wake up with the conditions not being cured plus an addiction to oxycodone, withdrawal from which brings additional problems.

That seems to be the situation with the global economic situation. It has required increasing dosages of stimulus to keep the pain only somewhat at bay. And now other problems, like record government debt, require that the dosages be tapered back, even as the economy is unable to maintain the status quo without increasing dosages. [Forbes]

Others — including some at the Fed — think that it's about time to wind down the stimulus, despite the risks involved. "Inflation hawks at the Fed worry the sharp expansion in bank reserves could lead to future inflation, even if there are no signs at all of any imminent price pressures," say Kristen Hays and Francesca Landini at Reuters.

Charles Plosser, president of the Federal Reserve Bank of Philadelphia, supports such a plan. "The first step is to wind down our asset purchases by the end of the year in a gradual and predictable manner," he said. "I see little if any benefit from these purchases, and growing costs."

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