With Continued QE, the Fed Moves Farther Off the Map

After rapidly expanding the balance sheet, the Fed may have trouble finding its way back to normal.

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As the Fed gets deeper into its stimulus program, it's increasingly going off the map.

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They say that explorers used to write "here be dragons" on their maps to denote uncharted, potentially dangerous territory. Today, the Federal Reserve is deep in dragon territory, and the hope is they don't get irreparably lost on the way out.

As the Fed gets deeper into its stimulus program, it's increasingly going off the map. The Fed's latest stimulus policy of choice, quantitative easing, was virtually untested when the bank undertook it, Those massive asset purchases have led to a balance sheet whose size is skyrocketing, from less than $1 trillion in 2008 to over $3 trillion now. The question facing the Fed is how much is too much: $4 trillion? $5 trillion? $10 trillion?

The answer: No one has a clue.

[RELATED: Amid Strengthening Economy, QE3 End Nowhere in Sight]

The Fed balance sheet is currently around 20 percent of GDP. That's not entirely unprecedented; it last hit that level when the central bank held yields on treasuries down to finance World War II. But the balance sheet held at around 5 percent from the late 1970s onward. Now, it will continue to grow well past $3 trillion, and there's no guidance on what "too big" might be.

"There is no formal theory that addresses the issues of the optimal size of central bank balance sheets versus the size of the economy," says Adolfo Laurenti, deputy chief economist at Mesirow Financial, a Chicago-based financial services firm. "We are making these things up along the way with very little guidance from economic theory."

For those who aren't monetary policy wonks, the Fed balance sheet reflects the assets it has purchased. Over the course of three rounds of quantitative easing—which some call "printing money"—the Fed has put $2 trillion dollars out into the economy by buying U.S. debt and mortgage-backed securities.

The chief fear that comes with quantitative easing is that all of that newly printed money will spark inflation. That has not yet happened, but it easily could. The question with no answer is—even absent hyperinflation—when has the Fed printed too much money. According to one former Fed governor, there's no real boundary on that.

"In theory there is no limit. But in practice it is limited by market participants," says Randall Kroszner, a member of the Fed's Board of Governors from 2006 through 2009, and a professor at the University of Chicago's Booth School of Business.

[READ: Volcker Advises Against QE3 Hubris]

If the balance sheet gets too big, says Kroszner, it could lead to a "loss of credibility" for the Fed, as people start to worry about whether the Fed can "unwind" its balance sheet—how it moves all of those treasuries and mortgages off its books. In this sense, it's not just the size of the Fed's stock of assets, but also how it gets rid of them and reels some of that money back in that matters.

"I can understand why there isn't a consensus. It's not just the size but what you do with it," says Kroszner.

Thus far, banks have been sitting on roughly half of that money that the Fed has churned out, rather than lending it. That reluctance has limited the risk of inflation. But once inflation picks up, that could be a signal that it's time to pull back, and by that time, it may be too late.

In short, the problem of the Fed's balance sheet is more one of timing than of size.

"Typically the Fed has done two mistakes in exit strategies: they started too late, letting some imbalances build up too much," says Laurenti. When that happens, he says, the Fed is then forced to "engineer a recession of sorts," moving interest rates up to stop inflation from overheating, thereby also putting the brakes on growth.

For now, the balance sheet is just going to keep growing; the central bank's open market committee, the arm that sets interest rates, elected in its meeting this week to stay the course on QE3, buying $85 billion in assets each month, and indicated that it has no intention of stopping in the near future.

As that monthly $85 billion adds to the Fed's balance sheet, it makes the potential for a botched exit even bigger. In Laurenti's opinion, that's reason to be cautious.