RICHMOND (MNI) – The following is the second and final section of
the text of the remarks of Richmond Federal Reserve Bank President
Jeffrey Lacker prepared for the Regional Forum in Morgantown, W.Va.
Tuesday night:
Putting the whole picture together, I think the most likely outcome
for the rest of 2010 is that the national economy will grow at a
moderate rate — consumers spending will gradually pick up pace and
businesses will continue to expand outlays for equipment and software,
and these key components of demand should overcome any drag from
commercial construction or state and local government spending.
For West Virginia, the recession arrived later than for the rest of
the nation, with job losses only beginning in late 2008 and continuing
in recent months. Unemployment also rose later in The Mountain State,
jumping from a low 3.8 percent in October of 2008 to more than double
that rate in just a few months, continuing its sharp rise to a rate of
9.5 percent today. The strength in energy markets in early 2008 helped
delay the onset of the downturn here. In addition, the West Virginia
housing market did not experience the outsized gains of some other
states, and therefore home prices and residential construction have not
declined quite as sharply. While existing home sales in West Virginia
have risen consistently in recent months, residential construction
remains sluggish. With the late entry into recession, West Virginia
seems to be following a somewhat slower path to recovery, yet West
Virginia University’s Bureau of Business and Economic Research has
forecast modest job growth for the second half of this year, consistent
with the national jobs outlook.
Of course, there are always risks to any outlook. In the current
environment, the labor market could recover more slowly than many
expect, which would restrain consumer spending and dampen growth. But
household incomes and household confidence could also rebound more
vigorously than many expect, in which case consumer spending could pick
up more briskly. It is also worth mentioning a risk that seems
particularly prominent in this recovery; firms facing major
uncertainties surrounding federal policies on trade, the environment,
financial services, and until recently, health care. For a business
considering a commitment to new capital spending or new hiring, it can
be difficult to estimate after-tax yields for an endeavor in an
environment that is so rich with proposals for higher taxes and new
regulations. This risk could be particularly relevant to West Virginia’s
coal mining industry, where uncertainty has become especially elevated
over the past year. No matter how one stands on the environmental issues
involved, the changing regulatory landscape could well have a depressing
effect on investment outlays.
Turning now to the outlook for inflation and monetary policy, by
all accounts — from government data to reports we get from our own
surveys — inflation remains benign, averaging about one and a half
percent since early last year. The risk of a pronounced decline in
inflation has diminished substantially in my view. But we will need to
be careful as the expansion strengthens to keep inflation and inflation
expectations in check because experience has shown that an upward drift
in inflation expectations can be very costly to unwind.
To keep inflation contained, we will need to be careful about when
and how to withdraw the considerable monetary policy stimulus now in
place. This requires care during any recovery, but this time the Fed
will have two monetary policy instruments at its disposal, not just one.
The Fed traditionally has targeted the overnight federal funds rate,
which required appropriately adjusting the supply of monetary
liabilities (currency and bank reserves). Varying the fed funds rate
affects a broad range of other market interest rates, and thereby
influences growth and inflation. Since October 2008, as the bankers in
the room are aware, we have had the authority to pay explicit interest
on the reserve balances banks hold. This gives us the ability to vary
independently the amount of our monetary liabilities and a critical
overnight interest rate. So when the time comes to withdraw monetary
stimulus, the FOMC will be able to raise the interest rate on reserves
or drain reserve balances, or both.
The Fed has been working on two mechanisms by which we could drain
bank reserves — reverse repurchase agreements and a term deposit
facility. Both would amount to issuing Federal Reserve Bank debt to
absorb reserves. While these may be useful as contingency measures, my
preference would be to rely primarily on sales of the agency debt and
agency-guaranteed mortgage-backed securities that we have purchased over
the course of the last year. Such an approach would move us more rapidly
to a “Treasuries-only” portfolio, and thus more rapidly reduce the
extent to which our asset holdings are distorting the allocation of
credit. There is no reason why MBS sales at a steady, moderate,
pre-announced pace (as with our purchase program) needs to be disruptive
to the markets for those securities. In fact, by adding to the floating
private sector supply, it should improve market liquidity, which
reportedly has been hampered by our large-scale purchases.
Looking beyond the near-term challenges for monetary policy,
however, our economy does face several significant challenges over the
longer term. I will discuss two. One of these is the path of future
federal budget deficits implied by current and planned fiscal policies.
The government’s debt cannot grow indefinitely at a rate much faster
than the economy itself grows, so ultimately, something has got to
change — either taxes are raised, spending is reduced, or the real
value of the debt is eroded through an increase in inflation, an outcome
the Federal Reserve is committed to preventing. Failure to establish
credible plans for bringing the fiscal position back into balance is
likely to dampen economic growth, since growing government debt relative
to GDP would ultimately compete with private borrowing by businesses and
households.
Our financial system — particularly how it will perform in future
financial crises — will also pose considerable longer term challenges.
I have argued elsewhere that the most important step to containing
financial instability is to establish clear and credible limits to the
federal financial safety net, which has grown considerably as a result
of the crisis. Richmond Fed economists estimate that, given the
precedents set in 2008, nearly 59 percent of the liabilities of the
financial sector enjoy explicit or implicit government support, up
considerably from about 45 percent as of 1999. I believe that this
crisis, and the attendant expansion of the financial safety net, was the
result of there being no clear limits on the government’s legal
authority to protect the creditors of failing financial firms.
While the bills that have been passed in the Senate Banking
Committee and on the House floor express the desire to see losses
imposed on failing firms’ creditors, they provide the government with
wide-ranging discretion to designate financial firms as “systemically
important” and use public funds in their resolution. But the resulting
ambiguity about rescue policy is likely to just perpetuate the forces
that brought us “too big to fail” to begin with. Improved regulations
will contain the risks that brought us the last crisis, but new
risk-taking arrangements inevitably will arise that by-pass existing
regulatory restraints. If authorities allow creditor losses at one
failing firm, then creditors are likely to pull away from other similar
firms, fearing that authorities will forgo supporting them as well.
Authorities will feel compelled to resolve uncertainty about implicit
safety net support by expanding implied commitments. Subsequent
regulations will rein in the new arrangements, the danger of which will
by then be fully appreciated. But this just sets the stage for another
cycle of by-pass, crisis, rescue and regulation.
A discretionary safety net, with no set boundaries, only feeds this
cycle by giving market participants reason to believe that new, complex
arrangements ultimately will be protected. It requires an ever-growing
reach of financial regulation, and undermines the market discipline that
helps align financial risk-taking with broader societal interests. It
also diverts innovative resources and energies into less-productive
channels, like regulatory by-pass, and away from more fundamental
improvements to our standard of living. Striking and preserving the
right balance between the safety net, regulation, and market discipline,
is vital to ensuring that financial markets make positive contributions
to the resiliency and growth of our economy over the long run.
(2 of 3)
** Market News International **
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