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Fed's Real Challenge Comes With QE2 Exit

WASHINGTON ( TheStreet) -- Recent Federal Reserve Board statements confirm that the Board of Governors has every intention of completing its second phase of quantitative easing (aka QE2) and continuing unprecedented support for the recovery well into the future.

These actions shouldn't surprise anyone. The Fed has taken a very strong position that the recovery was feeble and that further easing outweighed the substantial downside risks. While the recent strength of the recovery has cast doubts about the merits of QE2, the Fed is sticking with it and continuing to manage the challenges associated with it.

Federal Reserve Chairman Ben Bernanke is staying on the path of quantitative easing.

In essence, the Fed has hitched its credibility to further easing, the logic of which will probably not be questioned -- at least this calendar year. This path may become more precarious as the Fed begins to craft its long-awaited exit strategy.

A number of factors will put pressure on the situation, including overheated emerging markets, record commodity prices and asset price surges in key U.S. sectors (think agricultural land prices). While it is true retail price increases are largely absent, current monetary policy is likely to create other imbalances that at some point will bubble to the surface and demand attention.

The dilemma for the Fed and its chief, Ben Bernanke -- as it has been since 2008 -- is how to shift course effectively without derailing the recovery. Raising short-term interest rates is the traditional course of action, but in this environment the impact may be limited. Selling assets and reducing the balance sheet is the other course of action and one the Fed has to pursue eventually. Handling market reaction to this shift will prove interesting for no other reason than the Fed has never before tried to dock this vessel.

Managing market expectations while handling the logistics of selling Treasurys in an environment of high federal deficits could be difficult, to say the least. An uncharted path may stir a fascination for some, but probably not for central bankers. The Fed needs to begin sorting out this long journey, even as it winds down QE2.

For investors, these issues need to be front and center.

This year is shaping up to be a very good one on a number of fronts as the recovery gains speed. Caution is warranted, though, for what may linger just beyond the horizon. For savvy investors, it is time to start paying even closer attention to where and how the Fed proceeds as it draws QE2 to an end.

The impending "exit strategy" may actually be more important than efforts to stimulate activity over the past year.

In other words, the real show may be about to begin.

>To submit a news tip, email: tips@thestreet.com.

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Paul Ballew is senior vice president of customer insights and analytics at Nationwide Mutual Insurance in Columbus, Ohio. Ballew previously served as a Fed economist, a partner for J.D. Power and a senior executive at General Motors.

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