–More Monetary Stimulus Likely Warranted Unless Outlook Improves
–Economy ‘Several Years’ Away From What Would Be Satisfactory for Fed
By Steven K. Beckner and Claudia Hirsch
Dudley did not specifically advocate a given amount of Treasury or
MBS purchases, but offered a rule-of-thumb: “Some simple calculations
based on recent experience suggest that $500 billion of purchases would
provide about as much stimulus as a reduction in the federal funds rate
of between half a point and three quarters of a point.”
He said “this estimate is sensitive to how long market participants
expected the Fed to hold on to these assets.”
If the FOMC does decide to buy more assets, Dudley said that “the
clearer and more credible the framework governing purchases, the greater
the likelihood that market participants would act in a manner that
helped the Fed achieve its objectives.”
In particular, he said the market must be confident in “the Fed’s
ability to exit when the time is right.”
Dudley said there should be such confidence because the Fed has
developed tools for draining or absorbing reserves, such as reverse
repurchase agreements and the term deposit facility and because it can
incentivize banks to hold reserves and not lend them through payment of
interest on reserves.
Besides, he added, “when the time is right, the Fed can always sell
assets. Such asset sales would lead to a rise in longer-term rates and
this would have a contractionary effect on the demand for credit.”
Dudley denied that the Fed would be “pushing on a string” by
depressing already very low long-term rates, contending that the impact
would be “significant.” He said lower long rates “would support the
value of assets, including houses and equities and household net worth”
and “would make housing more affordable and support consumption by
enabling households to refinance their mortgages at lower rates.”
He conceded there are a couple of potential “constraints” on the
effectiveness of asset purchases.
“The first constraint is the risk that the balance sheet expansion
might cause inflation expectations to become unanchored, leading to
higher risk premia,” he said, but again he said the “credibility” of the
Fed’s exit strategy should mitigate that risk.
He dismissed concerns that expanded Treasury bond buying would
create the perception that the Fed is “monetizing the federal debt.” He
said the Fed would merely be trying to stimulate the economy and halt
disinflation.
“Once these goals were accomplished, there would be no basis for
further purchases regardless of the government’s fiscal position because
additional purchases would not be consistent with this mandate,” he
said.
“The second constraint is that further balance sheet expansion
would increase the Federal Reserve’s interest rate risk by raising the
maturity mismatch between its assets and liabilities,” said Dudley, but
he said he is “confident there is nothing to worry about on this score.”
Dudley said the Fed could conceivably incur some losses when it
eventually has to sell its assets, but he suggested the Fed’s policy
goals are far more important.
“Our dual mandate does not state that we should do what is
necessary to promote full employment and price stability only at times
when we are virtually certain that in doing so we will make a profit,”
he said. “It directs us to promote full employment and price stability
at all times. Profits and losses in any given year are much less
important than getting the U.S. economy back to the highest level of
employment consistent with price stability.”
Dudley prefaced his comments with a mostly bleak assessment of the
economy. He said that, in recent quarters, “the pace of growth has been
disappointing even relative to our modest expectations at the start of
the year.”
He said consumers are increasing savings and not spending because
they are paying down their debts. Meanwhile, he said “many businesses
have been reluctant to hire.”
The recovery is not merely going through a typical “soft patch,” he
said. “This soft patch is a bit different. First, it looks like it
will last somewhat longer because the deleveraging process is not yet
complete. Second, the current weakness is somewhat more concerning
because it is occurring at a time that the central bank has already cut
interest rates to near zero.”
The post-boom deleveraging “adjustment process” is showing signs of
“significant progress,” he said, but “while we may be far along in the
adjustment process, it is difficult to judge just how much further we
have to go.”
What’s more, he said “there is no question that credit conditions
are still tight.” He said this is both because balance sheet problems
have forced financial firms to tighten credit underwriting standards and
because a decline in property prices has cut collateral values and made
refinancing hard to obtain.
And Dudley said “today’s low and falling rate of inflation — at a
time when interest rates are near zero — is a problem that is slowing
the adjustment process.”
“Low and falling inflation is a problem for several reasons,” he
explained. “First, low and declining inflation makes it harder to
accomplish needed balance sheet adjustments … .Lower inflation means
slower nominal income growth. Slower nominal income growth, in turn,
means that less of the needed adjustment in household debt-to-income
ratios will come from rising incomes.”
“Second, and even more importantly, low and falling inflation can
cause inflation expectations to decline. This is important because
inflation expectations are an important factor that influences actual
future inflation. Moreover, when inflation expectations decline, the
expected real cost of credit increases.”
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** Market News International **
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