By Steven K. Beckner
Yellen said the “output gap” — the difference between the
economy’s growth potential and actual growth — was a negative 6% in the
fourth quarter and said “I don’t expect the output gap to completely
disappear until sometime in 2013.”
And she said this “has important implications for inflation,” going
on to downplay inflation risks, stopping short of predicting outright
deflation.
“We have a tremendous amount of slack in our economy,” she said.
“When unemployment is so high, wages and incomes tend to rise slowly,
and producers and retailers have a hard time raising prices.”
“That’s the situation we’re into today, and, as a result,
underlying inflation pressures are already very low and trending
downward,” she continued, adding that “if the economy continues to
operate below its potential, then core inflation could move lower this
year and next.”
Yellen went on to downplay inflation fears growing out of the Fed’s
expansionary quantitative easing policies. Although the Fed has
increased the size of its balance sheet from $800 billion to more than
$2 trillion, she said this is not inflationary for two reasons:
“First, expanding the Fed’s balance sheet has not, in fact, led to
a surge in credit. Lending has been quite restrained. Banks have been
cautious as they seek to return to financial health, keeping much of the
money created by this expansion in their accounts with the Federal
Reserve.”
“Second, that balance sheet growth and money creation have taken
place at a time when the economy has been operating with enormous slack
due to insufficient private demand for goods. In other words, the
pressures pushing inflation lower arising from underutilization of the
economy’s resources have more than offset any upward pressure from our
special programs. The net result has been that inflation has trended
down.”
Yellen said that “as the recovery continues, the Fed will
eventually have to make sure that this balance sheet expansion does not
lead to inflation.” And she said the Fed will “have to get the timing
right for tapering off and ending our expansionary programs.”
But the Fed’s zero interest rate policy is “is currently
appropriate, in my view, because the economy is operating well below its
potential and inflation is subdued,” she said. “Consistent with that
view, the Fed’s main policymaking body, the Federal Open Market
Committee, last week repeated its statement that it expects low interest
rates to continue for an extended period.”
“I don’t believe this is yet the time to be tightening monetary
policy,” Yellen said. “But as recovery takes firm root and economic
output moves toward its potential, a time will come when it is
appropriate to boost short-term interest rates.”
She said the technical issues of reducing the balance sheet and
tightening policy are “manageable.”
“When the time arrives to push up short-term interest rates, we
won’t have to sell off the assets we have acquired, thereby shrinking
our balance sheet,” she said. “We can instead boost short-term rates by
raising the interest rate that we pay to banks on their reserves held at
the Fed. A hike in the rate we pay on these reserves will cause other
short-term money market rates to rise in tandem because banks will be
unwilling to lend in the money market at rates below what they can earn
in their secure Fed accounts.”
Yellen said she would eventually like to see the Fed’s balance
sheet “shrink toward more normal levels” and would “like the bulk of our
holdings to be Treasury securities, as they were prior to the crisis.”
But she said this should be done only slowly.
“Selling off some of our assets could play a role in this shift,
but my expectation is that the FOMC will reduce the size of our balance
sheet only gradually over time,” Yellen said.
Yellen said federal budget deficits and unfunded liabilities are a
long-term concern that must be addressed, but she defended record levels
of deficit spending during the financial crisis. And she said she is
“not alarmed by the current enormous deficits, calling them “transitory
and recession-related.”
Yellen also said there is no reason to fear that the deficits will
cause inflation, but she added an important caveat: so long as the Fed
retains its independence.
“Here’s the rub though,” she said. “I’ve just asserted that there’s
no link between deficits and inflation in advanced countries with
independent central banks. The word independent deserves special
emphasis because it is essential to a central bank’s inflation-fighting
credibility.”
“As long as monetary authorities have the freedom to fight
inflation without interference, then deficits won’t pull them off
course,” she continued.
The Fed’s independence must be maintained, she said at a time when
Congress is considering measures that would curtail it.
“Why does independence matter?” she asked. “A decision to raise the
Fed’s short-term interest rate target may be unpopular. It raises the
cost of funds for businesses seeking to borrow, invest, or hire, leads
to higher mortgage rates, and boosts the cost of government borrowing.”
“And here’s the connection to deficits: In the future, faced with
large and persistent federal budget gaps, some people might hope that
the Fed would help finance all that fiscal red ink by boosting the money
supply and tolerating a higher level of inflation,” she continued. “An
independent Fed would find it much easier to stay focused on its
statutory goals of maximum employment and stable prices.”
“An independent Fed would allow interest rates to rise if needed to
address inflationary pressures and resist calls to monetize the debt,”
she went on. “By contrast, a central bank independent might succumb to
demands to keep rates low, even if the economy were in danger of
overheating. To my mind, this is one of the greatest arguments for
preserving the Fed’s independence.”
** Market News International **
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