The Fed will have to tread carefully, however, because there is always the risk of destabilising markets and nipping in the bud any signs of returning economic growth. A growing economy remains the key, but as consumers start to spend more money (this makes up around two-thirds of US GDP), inflation will start to accelerate, interest rates will rise, and the huge problem of solving the US debt crisis will be right back in the shop window.
There are suggestions that the authorities may, at this point, develop another tack, notably if current Fed chairman Ben Bernanke is succeeded by a more dovish chairman. In this case, interest rates will inevitably rise - but not as fast as inflation. This will reduce the level of real yields and cut the value of the dollar, and these two factors will work nicely to reduce the size of the US external debt mountain. Effectively, foreign investors will be paying to lower the level of US debt. This is a worry because one of the obvious counters to this is for external debtor nations to manipulate currency exchange rates, perpetrators in the past including Japan and China, both significant holders of US debt.
Inflation itself also acts as a corrosive agent on the purchasing power of savings, while those relying on non-index linked income - like many pensioners - will suffer a significant fall in real income. But the alternative - a tougher monetary stance - looks even less palatable. In this scenario, a rise in real rates as quantitative easing is unwound quickly would help to underpin the dollar, while the consequent blow to economic growth would keep inflation low. Overseas investors would benefit, while domestic consumers would have to pay for higher borrowing costs - not good for the housing sector where the fledgling economic recovery has its roots. And, crucially, with US debt heading to exceed GDP in the next few years (without a drastic fiscal adjustment), the authorities will be faced with crippling levels of debt interest payments. Bond yields would have to rise even further to keep overseas investors on board, and a similar trend in the more fragile economies of heavily indebted nations could land us back where we started - with another sovereign debt crisis.
How far would the dollar have to devalue? Jan Dehn, head of research at asset manager Ashmore, points out that the last time the US was in a similar situation was in 1971. Following heavy fiscal spending and the Vietnam war, the dollar devalued from $35 an ounce against gold to $185 an ounce in just four years. But the fiscal imbalances this time are far larger, which suggests that the dollar could fall by a much bigger margin.
The point here is that the size of the debt pile in countries such as the US and the UK cannot be ignored for ever. True, a steady improvement in economic output will help to fill central government coffers, but the real catalyst to boosting growth rates - allowing higher inflation - is still in the cupboard. But there is only so long that central banks can get away with flooding the economy with newly printed money without adopting a formal stance on how to handle the almost inevitable return of upward pressure on inflation.
Investors Chronicle's economist Chris Dillow is on annual leave.
