By Steven C. Johnson
NEW YORK, July 21 (Reuters) - Federal Reserve Chairman Ben Bernanke told the market just what it wanted to hear on Tuesday when he promised the central bank has the will and the tools to guide the economy out of recession without spurring inflation.
But even as they cheered his words, which triggered a bond market rally, investors still harbor doubts that Bernanke can quickly drain the trillions of dollars pumped into the economy during the crisis once a recovery finally takes hold.
"It will be incredibly difficult for the Fed to agree when an exit strategy is necessary," said Lena Komileva, head of G7 market economics at Tullett Prebon in London. "Even getting all the Fed members to agree at what point the economy is finally on a sustainable path to recovery will be very difficult."
For now, that's not a problem. Bernanke told Congress on Tuesday that unemployment was likely to remain high into 2011, keeping consumer spending weak and economic recovery slow.
He implied that means the Fed will keep interest rates at zero for some time yet and continue to inject money into the economy through purchases of government and mortgage debt.
These unorthodox policies have ballooned the Fed's balance sheet and left the United States looking at a record $1.8 trillion deficit for the current fiscal year.
INFLAITON OR DEFLATION?
Alan Ruskin, international strategist at RBS Securities, said Bernanke's confidence likely stems from his belief that inflation is not a threat, at least for the next year or two. "The debate is: are we facing a deflationary threat or an inflationary threat. Implied in all this is that inflation is a bigger threat, but that's not a given," he said.
Indeed, signs that current policies are no longer needed -- easier bank lending standards, increased credit creation, higher consumer spending, a narrowing gap between the economy's current output and its full potential -- are still absent.
When recovery does start to gain traction, Bernanke said the Fed has a number of tools, beyond raising benchmark rates, that it can use to drain money from the system, such as paying interest on Fed deposits and selling some of its long-term securities.
But that's when things can get dicey, and investors and economists fear the potential for policy mistakes are large.
"They have no experience coming out of a great recession like this, so to argue they know exactly what to do concerns me," said Dan Seiver, professor of finance at San Diego State University.
"In the last few years, my confidence in the Fed has been somewhat shaken," he added. "They were behind the curve for a long time. There are plenty of smart guys there now, but they were there when the economy and markets fell apart, too."
PITFALLS APLENTY
The first issue is timing -- when does inflation become enough of a concern and U.S. growth look sustainable enough to warrant the start of the Fed's exit strategy.
"Because there is no clear model or indicator on what tools to exit with, that is where the fuzziness is," said Rudy Narvas, senior analyst with 4Cast Ltd in New York. "If you don't time it right, either you dip the economy back into recession, or you will fuel the inflationary fires."
What's more, all of the policy tools have imperfections. Typically, central banks drain money from the system by raising benchmark interest rates and selling securities, but the scope of the crisis makes the latter difficult, analysts said.
Once it completes its asset purchase plans, Bank of America-Merrill Lynch estimates the Fed will hold $1.25 trillion in Treasury, agency and private mortgage-backed debt.
Letting maturing bonds run off would take a long time to shrink the Fed's balance sheet. Bank of America-Merrill Lynch forecast it would cut Treasury holdings by just $77 billion in 2010.
Active sales of securities bring even bigger problems. "They can't fob huge amounts of paper onto the the market without having some seriously detrimental implications for long-term rates," RBS Securities' Ruskin said.
A worst-case scenario could include foreigners fleeing from the U.S. dollar and Treasuries, driving yields even higher and stopping a recovery in its tracks.
Other options are also fraught with difficulties.
Reverse repurchase agreements, in which the Fed sells securities with an agreement to buy them back later at a higher price, would help drain cash from the system.
But impaired balance sheets at the primary dealers with whom the Fed usually transacts such agreements mean the dealers may not be able to hold up their end if this tool is used on a large scale, said Bank of America-Merrill Lynch rates strategist Michael Cloherty.
Dealing directly with money market funds instead, he added, would risk triggering a financing crisis for the dealers, as a money fund that has the choice of dealing directly with the Fed or a dealer, would likely choose the Fed.
Interest payments on money banks hold at the Fed would also help but could be a political time bomb, Cloherty said.
"There will eventually be a situation where the Fed is paying the banking system something like 5.0 percent on $700 billion of reserves," he wrote in a research note. "That would mean the Fed would be paying the banking system $35 billion per year of what is ultimately U.S. taxpayer money in order to push up interest rates."
Of course, the Fed is still likely a year or more away from implementing an exit strategy, but even that's cold comfort.
"This is a certain uncertainty that will be with us for years," Tullett Prebon's Komileva said. "The only thing we do know is that the economy is just not there yet."
(Additional reporting by Kristina Cooke and Chris Reese in New York)