By Steven K. Beckner
(MNI) – The U.S. economy continues to face “significant
challenges,” including “stubbornly” high unemployment and small business
hesitance to expand due to tight credit conditions, Federal Reserve
Governor Kevin Warsh said Friday.
However, Warsh said the Fed must resist political pressure to keep
monetary policy easy “looser longer” than would be consistent with price
stability.
Warsh, in remarks prepared for delivery to a Shadow Open Market
Committee conference in New York, said the Fed must protect its
“hard-won” inflation-fighting credibility and monetary policy
independence.
That entails not getting involved in fiscal policy, said the former
investment banker, who also strongly opposed raising the Fed’s implicit
inflation target, as has been suggested by the International Monetary
Fund.
He said the Fed “will be tested” in the “tough times” ahead, but
expressed confidence that he and his colleagues will give a “forceful
rebuke” to demands for keeping interest rates too low for too long.
Should the Fed give in to political pressure and inflation
expectations become “unmoored,” he warned that long-term rates would
eventually arise. And dollar holders could flee into other currencies
and hard assets.
Warsh’s topic was “An Ode to Independence,” and he devoted most of
his speech to that topic. But he began with some brief comments on
economic and financial conditions that seemed to reflect the cautious
views of other Fed policymakers, including Chairman Ben Bernanke, that
have spoken in recent days.
“The overall profitability and balance sheet strength of large U.S.
enterprises is impressive at this stage of recovery,” he began. “Equity
prices and credit terms in liquid markets corroborate these improved
fundamentals. And for these firms, financial market conditions appear
quite supportive of economic growth.”
“Still, significant economic challenges persist,” Warsh continued.
“While recent trends in personal consumption and business investment
trends are positive, the underlying strength of the economy over the
medium term is less clear.”
“Unemployment remains high, and stubbornly so,” he went on. “Small
and medium-sized enterprises, which have tended to lead recoveries, are
still hesitant to expand — revenue growth is tepid, costs are
uncertain, and credit conditions remain more difficult than for large
firms.”
Warsh also noted that “increases in government expenditures around
the world … are raising fiscal deficits significantly” and “raising
concerns in sovereign debt markets.”
“Taking account of the broad range of economic and financial
conditions, there is no wonder that the electorate — in the United
States and abroad — is unnerved,” he added.
Against that backdrop, Warsh said, “monetary accommodation from the
world’s largest central banks remains extraordinary.” But as and when
the time comes to withdraw some of that accommodation, he warned that
the Fed’s independence and in turn its credibility may increasingly come
under assault.
He called the Fed’s credibility its “greatest asset” and said it is
“essential: It increases the heft of our communications. It gives weight
to our economic assessments. It amplifies the effect of announced
changes in the short-term policy rate on longer-term rates. It is, in
some sense, the real money multiplier in the conduct of policy.”
But the Fed’s credibility is “no birthright,” he said. It had to be
earned and required “fierce independence from the whims of Washington
and the wants of Wall Street, and from a pernicious short-termism that
can undermine the proper conduct of policy.”
Both the Fed’s independence and its credibility are now on the
line, in Warsh’s view.
“Central bank independence is precious,” he said. “It can be taken
for granted in benign times, but it is tested when times get tough. And
we still have tough times ahead of us.”
“My colleagues and I must demonstrate that Fed independence has not
been relegated, and the Fed’s long-term objectives not compromised,” he
continued. “Ensuring Fed independence–as the cornerstone of
institutional credibility — is our charge to keep.”
“(D)eclarations of independence by Fed policymakers are
heartening,” Warsh said. “But independence is ours to demonstrate, not
principally to declare.”
Congress is perfectly capable of taking away the Fed’s monetary
policy independence, so the Fed must carefully guard it, he said,
emphasizing that monetary policy must be distinguished from the Fed’s
other regulatory functions, which he said are not independent.
And the Fed must “steer clear” of fiscal policy, he said,
“(F)iscal and monetary policies tend to blur in these times of
crisis,” Warsh said. “Capital and liquidity issues become difficult to
disentangle at troubled institutions.”
“(W)well-intentioned policymakers are compelled to make tough
judgments amid significant time constraints,” he said. “What constitutes
an emergency liquidity provision backed by good collateral at a penalty
price? And what is more aptly characterized as a fiscal provision to
bolster capital?”
The Fed “must do its utmost to stay foursquare within its role as
liquidity provider,” Warsh said, adding that if Congress gives the Fed
enhanced financial stability responsibilities it “should not give
license to central bankers to be emergency capital providers.”
Providing capital should be up to Treasury, not the Fed, he said.
“The Fed, as first-responder, must strongly resist the temptation
to be the ultimate rescuer,” he said. “No matter the congressional
calendar or the pleadings of the elected, the Fed is not a repair shop
for broken statutes or broken financial ecosystems.”
“The Fed’s credibility is severely undermined if it is perceived to
wander from its mission into areas more appropriately handled by other
parts of government,” he added.
Warsh also cautioned about two other “pressure points” that could
undermine the Fed’s independence and credibility, most notably to help
finance deficit spending.
“First, governments may be tempted to influence the central bank to
keep monetary policy looser longer to finance the debt and stimulate
activity,” he said.
“In the more static short-run, the real burdens of nominal debt
could be reduced by higher inflation,” he said, but “the consequences
just over the horizon, however, would be most unwelcome.”
“Higher expected inflation would lead to higher nominal interest
rates, increasing the financing needs of the government yet further,” he
continued. “Moreover, higher expected inflation could lead to more
variable inflation outcomes and reduced living standards, especially for
those least able to protect themselves from unexpected price movements.”
Warsh said Fed officials must “take their own counsel when deciding
upon the timing and force in removing monetary policy accommodation,”
and he said he is “confident that any attempt to influence
inappropriately the conduct of Fed policy would yield a strong and
forceful rebuke by Fed officials and market participants alike.”
A second threat to credibility of which Warsh warned lies in calls
for the Fed and other central banks to modify their definitions of price
stability — the idea being that if inflation persisted at higher levels
during normal times, central banks could cut rates more substantially in
response to economic weakness.
But Warsh said that theory “fails the real test of experience.”
“Central banks that desire just a little more inflation may well
end up with a lot more,” he said. “Some point to a strategy to accept a
little more inflation for less unemployment as a primary basis for the
great inflation of the 1970s in the United States.”
“By definition, an increase in an implicit inflation target would
lead to an upward shift in inflation expectations,” he said. “And how
would a central bank make credible its promise that such a shift would
be only a one-time event?”
“We do not understand sufficiently the determinants of inflation
expectations to be confident that a regime change can be controlled,”
said Warsh.
“Central banks, here and abroad, have worked for decades to get
inflation down to levels consistent with price stability,” he said. “We
should not risk these hard-won gains.”
“In changing the goal posts at this time of consequence,
substantial harm would be done to a central bank’s institutional
credibility, and perhaps lead to an unmooring of inflation
expectations,” he continued. “Such damage could lead investors to seek
alternative currencies, with prices of commodities and other hard assets
likely to increase.”
** Market News International **
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