Two Federal Reserve policy makers rejected a warning from economists that potential losses on the Fed’s $3.1 trillion balance sheet may undermine central bank control of monetary policy.
Boston Fed President Eric Rosengren said today “this discussion does not do justice to the policy trade-offs” of the Fed’s large-scale asset purchases, referring to a paper written by four economists, including Frederic Mishkin, a former Fed governor and co-author with Chairman Ben S. Bernanke. Fed Governor Jerome Powell dismissed a suggestion policy makers won’t act to curb inflation.
The Fed’s hold on policy may weaken should possible losses on its balance sheet coincide with high U.S. budget deficits and an inability of Congress and the White House to put fiscal policy on a sustainable path, according to the economists’ paper presented at the U.S. Monetary Policy Forum in New York. The audience included at least eight policy makers on the Federal Open Market Committee.
“The combination of a massively expanded central bank balance sheet and an unsustainable public debt trajectory is a mix that has the potential to substantially reduce the flexibility of monetary policy,” the economists said. “This mix could induce a bias toward slower exit or easier policy, and be seen as the first step toward fiscal dominance. It could thereby be the cause of longer-term inflation expectations and raise the risk of inflation overall.”
One source of risk is possible criticism from Congress, Mishkin said during the conference.
“We are in a period where the attacks on the Federal Reserve System are the worst I’ve seen in my 40 years as a monetary policy economist,” he said. Concern about any evaporation of Fed profits could “come up big time in Congress.”
The Fed is currently purchasing $85 billion a month of Treasuries and mortgage-backed securities, following two previous rounds totaling $2.3 trillion, in an effort to lower an unemployment rate stuck near 7.9 percent. Once the economy strengthens, the central bank plans to unwind its balance sheet by raising interest rates and selling many of the assets acquired over the past four years.
Rosengren said the economists’ paper on the large-scale asset purchases “highlights a potential problem” that the Fed’s remittances to the U.S. Treasury may fall.
Still, “the LSAP program improves the broader fiscal outlook by lowering interest rates and providing more economic growth,” while also helping the Fed promote full employment and hit its 2 percent inflation target, he said. “We do well to also consider these benefits, and the costs of inaction, when evaluating policy.”
A model used by the Boston Fed estimates that an additional $750 billion in asset purchases would reduce long-term interest rates by 0.2 percentage point to 0.25 percentage point, resulting in a $260 billion gain to economic output, Rosengren said. The model also estimates the stimulus would lower the jobless rate, he said.
Policy makers and economists at the conference debated whether the central bank should be concerned about the prospect of losses.
The Fed would sell assets as a stronger economy generated higher tax revenue, said Julia Coronado, a former Fed economist and chief economist for North America at BNP Paribas in New York. “What a beautiful world that will be.”
St. Louis Fed President James Bullard said he’s “not so sure it’s a beautiful world.”
Paying billions in interest on excess reserves at a time the Fed is paying nothing to the Treasury “sounds like a recipe for political problems,” he said.
Powell said in a paper that policy makers “have the flexibility to normalize the balance sheet more slowly.”
“For example, a ‘no asset sale’ plan -- under which assets would simply run off as they mature -- would push out the date of normalization by only a year or so,” he said. “That approach would also address concerns over potential market disruption.’
Powell’s remarks are a departure from the Fed’s current “exit strategy,” adopted in June 2011, which calls for selling assets to return the balance sheet to a normal size and composition.
“Unfavorable fiscal arithmetic might tend to push the Fed toward delaying its exit from the extraordinary easing measures it has taken in recent years; it could even affect decisions this year about how much further to expand the Fed’s holdings of longer-term government securities,” the economists said.
“The Fed could cut its effective drain on the Treasury significantly by putting off asset sales and delaying policy rate increases,” they said. “But such a response would presumably feed rising inflation expectations.”
Powell said the central bank may come under fire after a period of not turning a surplus over to Treasury.
The Fed recently released a paper showing that the income it has traditionally earned from its policies could disappear for years as interest rates rise. After paying its expenses, the central bank returns any surplus to Treasury to help fund the expenses of the U.S. government. In 2012, the Fed returned $88.9 billion to taxpayers.
“An extended period of zero remittances could certainly bring the Federal Reserve under criticism from the public and Congress,” Powell said.
“The question is whether the Federal Reserve would permit inflation and thereby abandon its post in the face of such criticism,” he said. “There is no reason to expect that to happen.”
The U.S. Monetary Policy Forum is sponsored by the Initiative on Global Markets at the University of Chicago Booth School of Business.
In addition to Mishkin, now an economist at Columbia University, the authors of the paper are David Greenlaw, chief U.S. fixed income economist for Morgan Stanley; James D. Hamilton, a professor of economics at the University of California in San Diego; Peter Hooper, chief economist at Deutsche Bank Securities Inc.
Hooper and Greenlaw are both former Fed economists, while Hamilton’s research on bond yields has been cited by Bernanke as justification for the Fed’s policies.
The audience at the conference included Fed governor Jeremy Stein, the New York Fed’s William C. Dudley, Narayana Kocherlakota of Minneapolis, John Williams of San Francisco and Dennis Lockhart of Atlanta.
The Standard & Poor’s 500 Index rose 0.6 percent to 1,512.14 at 3:01 p.m. in New York, while the yield on the 10- year Treasury note slid one basis point, or 0.01 percentage point, to 1.97 percent.
The Congressional Budget Office forecasts that the government will run deficits averaging nearly $700 billion from 2014 to 2023 in its baseline scenario.
“The bottom line is that no matter how strong the commitment of a central bank to an inflation target, fiscal dominance can override it,” the economists said in their paper. “Without long-run fiscal sustainability, no central bank will be able to keep inflation low and stable.”
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Caroline Salas Gage in New York at email@example.com
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