If Federal Reserve officials think U.S. homeowners are having a
tough time selling into a depressed market, just wait until they try to
offload the mother of all jumbo mortgages: a $366 billion portfolio of
real estate bonds that continues to grow.

In this light, an eventual exit strategy from the Federal Reserve's
multi-trillion dollar emergency measures might be viewed as the central
banking equivalent of flipping houses, but on an epic scale.

It is not an enviable task. The U.S. central bank must weigh the
necessity of removing reserves from the economy, because of potential
inflation, against the reality that selling mortgage-backed securities
could further dent that battered market, possibly pushing up mortgage

A large chunk of the Fed's rescue efforts is a commitment to
purchase as much as $1.25 trillion of mortgage securities issued by
mortgage giants Fannie Mae and Freddie Mac.

Outstanding Fed credit, commonly referred to as the central bank's
balance sheet, was historically composed mostly of highly-liquid U.S.
Treasury bonds. Before the crisis started in the summer of 2007, 92
percent of its holdings of about $855 billion were made up of
government debt, according to official central bank data.

As of May 7, 2009, the Fed's overall balance sheet has expanded to
over $2 trillion, of which only about a quarter is Treasuries, with
mortgage debt representing a growing slice of the Fed's asset base,
according to the Fed's weekly H.4.1 report. (here)

It's going to be a massive undertaking, especially given the size
that we are likely to see before all is said and done, said Kim
Rupert, managing director of global fixed income analysis at Action
Economics LLC.

Ben Bernanke, the Fed's current chairman, and his number two, Donald
Kohn, have been quick to state they have plenty of ways of removing all
the liquidity that has been injected into the financial system when the
time is right.

We have a number of tools we can use, Kohn said in a recent
speech. Among other capabilities, Kohn touted the newly acquired
ability to pay interest on reserves held with the Fedwhich would give
the central bank the ability to attract more deposits and restrain bank
lending if inflation crept higher.

This could happen, analysts note, even without a substantial
recovery in economic growth through a sharp selloff in the U.S. dollar,
rising commodity costs, or both. Such fears are beginning to be
reflected in interest rate futures markets, which are now pricing in a
Fed interest rate increase, up from the current zero to 0.25 percent
range, by year-end.

The threat of inflation is one that we need to be attentive to, in
part because of the enormous borrowing on the part of the U.S.
Treasury, said David Resler, chief economist at Nomura Securities.

Resler is in good company. Such concerns have been raised by
prominent policy veterans like Paul Volcker, the former Fed Chairman
who now advises President Barack Obama, and former U.S. Treasury Undersecretary John Taylor.

In a recent analysis, Taylor concluded that there is a systemic
risk of inflation as a result of the excess reserves. Coming from the
father of the so-called Taylor rule, widely used in central banking,
which determines the ideal interest rate for a given set of economic
conditions, his conclusions were unsettling.

My calculation implies that we may not have as much time before the
Fed has to remove excess reserves and raise the rate, he said at an
Atlanta Fed conference this week.


Attuned to such discontent, Bernanke has led a charge in the central
bank's defense. Central to Bernanke's case is the notion that the Fed's
programs are self-liquidating, meaning that an improvement in
financial markets will automatically reduce the need for them.

This may indeed be true in certain instances. The Term Securities
Lending Facility, one of the early efforts that sought to ease a
squeeze on the Treasury market that came from a crisis-driven demand
for safe-haven debt, has recently run out of demand as market
conditions appeared to stabilize.

The same would likely happen with the international currency swaps aimed at meeting foreign demand for U.S. dollars.

However, full withdrawal from other credit creating programs,
particularly the Fed's acquisition of mortgage bondswill not be simple.

Part of the problem hinges on Fed's ability to return all the
mortgage debt it has taken on, at the risk of derailing a housing
market that is expected to remain fragile for years.

Another concern is that, because inflation is generally a lagging
indicator, it will not give policy-makers enough lead time to remove
the stimulus.

At such time as they do see an upturn in the economy or begin to
see inflation it's going to be too late to worry about an exit
strategy, said John Williams, economist and founder of ShadowStats, a
statistical analysis research firm in Oakland, California.