Inflation hawks never sleep

It's never too early to start thinking about shutting down the stimulus, says Richmond Fed president Jeffrey Lacker


Andrew Leonard
August 27, 2009 6:35PM (UTC)

Thursday morning's economic data points do not offer much grist for the fortune-teller. The Commerce Department's revised negative 1 percent estimate for second quarter economic growth was "surprisingly unchanged," according to the Wall Street Journal. Initial jobless claims fell, which was encouraging to see after two weeks of rising claims, but they didn't fall by very much.

Nonetheless, the drumbeat from inflation hawks looking to rein in all forms of stimulus continues to build. For a nuanced explication of this line of argument, it's worth taking a close look at a speech given this morning by Jeffrey Lacker, president of the Federal Reserve Bank of Richmond. Lacker has consistently been one of the Fed's most devoted inflation hawks. In 2006, as a member of the Fed's Policy Committee, he dissented four times from decisions by the Fed to either pause or lower interest rates, deeming inflation to be a bigger threat than a slumping economy.

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As has been discussed here before, the Obama administration is determined not to repeat the mistakes of 1937, when premature fiscal and monetary tightening aborted a nascent economic recovery. Obama's economic advisors would prefer to see solid, consistent economic growth for an extended period before making any moves to directly cut deficits.

But according to Lacker, "keeping inflation well-contained may require action before a vigorous recovery has had time to establish itself." So in other words, we may need to stop giving the economy medicine before we know whether the patient is fully healthy.

One of the ways in which the Federal Reserve has provided stimulus to the financial sector is by buying assets -- "up to $300 billion in U.S. Treasury securities, up to $200 billion in agency debt, and up to $1.25 trillion in agency mortgage-backed securities." By buying mortgage-backed securities from the banks, the Fed is in effect boosting the capital reserves of those banks, in an apparently successful effort to ease tight credit. But at some point, says, Lacker, enough will be enough.

In a statement after the last FOMC meeting, the Committee announced that it would gradually slow the pace of Treasury purchases and complete them by the end of October. Purchases of agency debt and agency mortgage-backed securities continue ... Should those purchases continue at their current pace, there will come a point at which the banking system will no longer need to borrow to obtain the desired level of reserve balances. At that point further asset purchases would then push the supply of reserve balances beyond demand, and would necessitate a downward adjustment in other yields to induce banks to voluntarily hold large balances. This would provide discretely more monetary stimulus than past asset purchases have provided thus far, since arguably such purchases have until now simply displaced bank borrowing from the Fed. With the economy leveling out and beginning to grow again later this year, and with bank reserve demand ebbing as financial conditions improve, I will be evaluating carefully whether we need or want the additional stimulus that purchasing the full amount authorized under our agency mortgage-backed securities purchase program would provide.

Bloomberg News seized upon the last line of Lacker's speech and declared that "Lacker Says Fed May Not Need to Buy All $1.25 Trillion of Mortgage Bonds."

Lacker was most likely dead wrong when he pushed for higher interest rates in 2006, and he continued to be wrong in 2007 and 2008, when he downplayed the likelihood of an oncoming recession. He wasn't alone in his complaisance, but that doesn't mean his observations should be ignored. Instead, they provide a clear road map as to what to watch in upcoming months. If the Federal Reserve does start to pare down its purchases of mortgage-backed securities, it will be an unmistakable clear sign that confidence in the sustainability of an economic recovery is growing.

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Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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