By Kristina Cooke

If they wait too long, they risk sky-high inflation or another asset bubble. If they move too fast, they risk undermining any incipient economic recovery.

Even against the current backdrop of a miserable economic outlook and the specter of deflation, a growing number of voices are warning that the Federal Reserve needs a clear and credible exit strategy for its unprecedented policies.

The Fed's balance sheet has more than doubled in size to over $1.2 trillion in recent months as policy-makers sought to shield the economy from the worst financial crisis since the Great Depression by pumping liquidity into key credit markets.

"All roads lead to inflation and the economy will be very precariously perched when the Fed starts reversing its policy," said Michael Pento, senior strategist at Delta Global Advisors. "It's sophomoric and naive to think there is any way out of this without a lot of pain."

While the Fed has not gone into detail on how it might go about withdrawing its extraordinary support for credit markets and the economy, the subject is clearly on the minds of policy-makers.

At a recent symposium at Columbia Business School, New York Federal Reserve Bank staffer Til Schuermann asked a panel of academics: "How should we, the Fed, think about an exit strategy?"

The answer from Tano Santos, a professor of finance at Columbia: Timing will be crucial.

U.S. Securities and Exchange Commission Chairman Christopher Cox last month urged policy-makers to answer tough questions about exit strategies now and not "stumble along a dangerous path of confusion," while Glenn Hubbard, dean of Columbia Business School, counts unwinding the liquidity programs among the top challenges facing policy-makers.

SELF-LIQUIDATING

Many of the Fed's emergency facilities have been built with the intention they self-liquidate, said Stuart Hoffman, PNC Financial's chief economist. In other words, when the economy and credit markets improve, it won't make sense for firms to tap the facilities when they can borrow cheaply elsewhere.

"It could be easy, but it's all conditional on getting back to a strong economy and bank balance sheets that are trustworthy again," said Michael Feroli, U.S. economist with JPMorgan in New York.

Demand from banks for short-term funding under a Fed facility set up in December 2007 has already begun to wane. Analysts say the narrowing in the Term Auction Facility's bid-to-cover ratio suggests banks have less need for the program and are meeting their funding needs elsewhere.

But emergency lifelines that target companies and consumer borrowing could be more of a headache, said PNC's Hoffman, and there could be false signals and starts.

Loans under a program to help market participants meet credit needs of households and small businesses, the Term Asset-Backed Securities Loan Facility, for example, have a three-year maturity, which could complicate the wind-down.

A commercial paper facility, which addresses non-financial companies' short-term funding needs, may also need to be actively wound down by reducing volume and raising borrowing costs to force companies to tap the market instead, Hoffman said.

Different sectors recover at different times when the economy picks up and if only a handful of firms tap a facility, it would be hard to argue the programs are still needed.

Policy-makers may also have to contend with political pressure not to quash a burgeoning economic recovery by unwinding their emergency support, especially for programs aimed at consumers.

When the Bank of Japan ended its quantitative easing regime in 2006, politicians wanted it to remain in place longer. Japan's economy remains in a slump.

Perhaps, as Columbia Business School's Hubbard told the symposium on the financial crisis he hosted last month, the Fed should bear in mind that "riding a flying dragon is easy, landing is difficult."

(Editing by Leslie Adler)