Monday, August 24, 2009

Fed Officials Warned Against "Timidity"

Article found as reported by the Wall Street Journal's Blog:

By Maya Jackson-randall
JACKSON HOLE, Wyo. — While U.S. Federal Reserve officials will need to be careful not to raise interest rates too soon, the central bank can’t be timid once it actually moves into a tightening phase, according to University of California, Santa Cruz Professor Carl Walsh.

In a paper prepared for a two-day Fed conference here, Mr. Walsh argued that the U.S. must avoid the mistake of the Bank of Japan in lifting rates too soon. The way to do that is to keep rates low past the point at which the economy’s equilibrium, or natural, real rate of interest has risen above zero, he said.

However, once the Fed does start raising the federal-funds rate out of its current record-low range near zero, “it should be increased quickly,” Mr. Walsh argued. “There is no support for raising rates at a gradual pace once the zero rate policy is ended.”

Mr. Walsh is one of several key speakers at the Kansas City Fed’s two-day symposium in Wyoming. Central bankers and academics have gathered here from around the world to discuss monetary and fiscal policy this weekend. A common theme at Friday’s session was that while there are encouraging signs in the economy, the crisis is not over.

Mr. Walsh wrote about a variety of hot-button economic issues in his paper, intended for presentation to a group of academics and international finance officials, and at points criticized the Fed. For instance, Mr. Walsh noted that the Fed has promised to keep rates low for an extended period while also promising to keep inflation stable. That policy seems to be the wrong approach when rates are in a range near zero, Mr. Walsh argued.

He also criticized the Fed’s move to purchase long-term U.S. debt, a unique program the Fed announced earlier this year as a way to help bring down borrowing costs amid signs the economy was deteriorating further.

“If purchases of long-term debt are effective in stimulating aggregate demand, there remains the question of why they should be carried out by the central bank,” he said. “These operations shorten the maturity structure of the Treasury’s outstanding debt.”

He added that the Treasury Department itself can alter the composition of outstanding publicly held debt. “There is no reason this should be done by the central bank,” he said.

Additionally, Mr. Walsh voiced concerns about the Fed’s plans for withdrawing from its costly programs to stem the financial crisis. He noted that one of the ways the Fed plans to tighten is by raising the interest rate paid on bank reserves. In principle, the Fed could drop using a target federal-funds rate as a policy instrument and replace it with a policy that focuses on the rate paid on reserves — something that may be less politically supportable, according to Mr. Walsh. If the Fed plans to make such a change, it will need to communicate it clearly, he added.

“Markets, and the public, appear to understand monetary policy decisions under a regime of targeting the funds rate,” Mr. Walsh wrote. “While a channel system may allow better control of the funds rate, there are potential pitfalls in using the rate paid on reserves as the main instrument and the focus of communications.”

Mr. Walsh also touched on the issue of whether the Fed should be in the business of popping asset-price bubbles such as the recent real-estate bubble and the technology stock boom years prior. While these distortions generate economic inefficiencies, it doesn’t mean that its best to use monetary policy to address them, said Mr. Walsh.

“Ideally, a time varying fiscal tax/subsidy scheme would be a more appropriate policy,” he said. Still, if regulations or subsidies are not enough to mitigate troubles, “central banks cannot ignore financial frictions and financial stability,” he said.

There is little doubt that the U.S. made a mistake by allowing the bubble in housing prices to continue, Mr. Walsh said.

“Monetary policy may also be a blunt instrument for dealing with asset price bubbles, but allowing bubbles to continue and then to burst imposes a tremendous cost on the economy,” he said. “Undoubtedly, future policy makers will be more willing to risk undertaking policies to deflate incipient bubbles, through the difficulty of identifying them with certainty will always remain.”

For a link to the Wall Street Journal's Blog, click here.


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