Richmond Federal Reserve Bank President Jeffrey Lacker raised strenuous objections to both the Fed's asset purchases and its communications strategy Tuesday, while suggesting that the central bank's credit policy is "adrift."
What's more, the Fed is not abiding by its own accord with the U.S. Treasury, inked in March 2009, designed to limit "credit allocation" by the Fed and insulate it from involvement in "fiscal" matters.
Lacker, a voting member of the Fed's policymaking Federal Open Market Committee who has dissented at every FOMC meeting this year, did not speak about the economic outlook or about future monetary policy choices. But he left little doubt that he will continue to oppose large-scale asset purchases, particularly buying of mortgage-backed securities.
He questioned the effectiveness of this so-called "quantitative easing," as well as the propriety of trying to lower interest rates in one sector, housing, at the expense of others, such as small business, in remarks prepared for delivery to a Shadow Open Market Committee conference in New York City.
Lacker was equally vociferous in challenging the FOMC's effort to stimulate the economy by trying to convince markets and the public that it will keep the federal funds rate near zero for an extended time period.
Lacker will have a final chance to dissent when the FOMC reconvenes Dec. 11-12.
The Fed's "Maturity Extension Program" or "Operation Twist," under which it has been buying $45 billion per month in long-term Treasury securities, is set to expire at year's end. Some of his colleagues have advocated fully replacing those purchases, which have been financed by the sale of an equal amount of short-term Treasuries, by outright purchases financed by the creation of new bank reserves.
In effect this would mean an expansion of the third round of quantitative easing (QE3), which now takes the form of $40 billion per month of MBS purchases, to $85 billion per month.
Lacker supported the Treasury purchase component of QE1, but explained that he has since opposed Fed asset purchases because they have "increasingly focused on altering the composition of the Fed's asset holdings in order to affect the net public supply of assets with particular characteristics and thereby affect their relative prices."
"There is ample room for skepticism about the effect of the Fed's asset purchases on asset returns," he said. "The empirical evidence on the effects of Fed asset purchases, which is based on yield movements around the announcements of asset purchases, is ambiguous, given the difficulty of parsing policy signals from pure supply effects."
"When the Fed expands reserves by buying private assets, it extends public sector credit to private borrowers," he said. "To the extent that purchases of private claims have any effect, they do so by distorting the relative cost of credit among different borrowers. Such differential effects are unlikely to be beneficial, on net, unless borrowers in the favored sector would otherwise face artificially high rates."
Lacker said "it's difficult to make this case for agency MBS, a sector that historically has benefited from heavy subsidies, which arguably contributed to dangerously high homeowner leverage. So I do not see the rationale for reducing the interest rates paid by conforming home mortgage borrowers relative to those paid by, say, small-business borrowers."
Besides, Lacker said purchasing agency MBS "encourages the continuation of a housing finance model based heavily on government-sponsored enterprises, at a time when the housing sector would be better served by a new model that relies less on government credit subsidies."
On March 23, 2009, as the Fed was engaged in an array of unconventional and unprecedented efforts to counteract the financial crisis, it signed a Joint Statement with the Treasury which, among other things, said "decisions to influence the allocation of credit are the province of the fiscal authorities."
Fed MBS purchases violate that accord, according to Lacker, who warned, "the apparent contradiction between the March 2009 Treasury-Fed statement and the FOMC's recent interventions to steer credit to the housing market also may be contributing to the perception that Federal Reserve credit policy is adrift."
Lacker likened selective Fed asset purchase policies to the "constructive ambiguity" about its willingness to rescue financial firms practiced by the Fed leading up to the bail-out of Bear-Stearns in March 2008, which fuelled expectations of subsequent bail-outs that weren't fulfilled in the case of Lehman Brothers six months later.
"Constructive ambiguity became increasingly hopeless in the face of accumulating instances of intervention, and the toxicity of credit policy opacity is now quite clear," he said. "Financial stability is likely to remain elusive without constraints on ad hoc rescues of firms facing financial stress."
By using its capacity to expand its balance sheet to "direct the flow of credit toward particular market segments," the Fed is "circumventing the constitutional checks and balances that would otherwise apply to such fiscal initiatives" and risking "entanglement in partisan politics," Lacker warned.
Lacker noted that the Dodd-Frank Act limited Fed lending to non-depository institutions in "unusual and exigent circumstances" under its Section 13(3) authority. But he said those restrictions are too "modest."
"If the Federal Reserve cannot limit credit policy of its own accord, legislation may be the best option," he said. "And the restraint of credit policy would not be complete unless limits on reserve bank lending are complemented by limits on the Fed's ability to buy private sector assets."
Lacker also questioned the Fed's use of "forward guidance" on the path of the funds rate, most recently its twin assertions that the funds rate is likely to be kept near zero "until at least mid-2015" and that monetary policy will stay "highly accommodative ... for a considerable time after the economic recovery strengthens."
The FOMC's aim is to stimulate the economy by "assuring the public that it will keep its interest rate target at the zero bound longer than it would if it were following its normal pattern of behavior," but Lacker said "it's not clear whether this mechanism can work ... without raising expected inflation over some horizon."
He said "adopting such a strategy without compromising longer-term credibility may be feasible in model environments, where absolute credibility can easily be assumed."
But in practice "a central bank's credibility is often contingent and incomplete," and "the Fed's credibility is not so unassailable that inflation expectations can be dialed up for a time and then easily dialed back to price stability."
"At the very least, the precedent set by an opportunistic attempt to raise inflation temporarily is likely to cloud our credibility for decades to come," he warned.
Lacker indicated he wouldn't oppose laying out a set of economic conditions for raising the funds rate and/or shrinking the Fed's balance sheet -- as opposed to using a moveable calendar date. But he cautioned against "spurious precision," a phrase he used in a recent MNI interview.
In an obvious reference to proposals by Chicago Fed President Charles Evans and others, he noted, "Some of my colleagues have suggested that the Committee provide specific numerical thresholds to help characterize future policy. For example, they suggest that the Committee state that interest rates will be exceptionally low at least until the unemployment rate falls below some specific number, as long as inflation is projected to be close to the Committee's 2% objective, and inflation expectations remain stable."
But Lacker said such an approach would place too much weight on a single indicator of labor market conditions, unemployment, which "can easily lead you astray."
"Crisp numerical thresholds may work well in the classroom models used to illustrate policy principles, but one or two economic statistics do not always capture the rich array of policy-relevant information about the state of the economy," he said.
Nor was Lacker convinced that the economy would be protected from rising inflation and inflation expectations by numerical thresholds.
So-called "safety valves" in numerical threshold schemes which provide that the funds rate will be kept near zero so long as inflation stays below a certain rate (3% in Evans' case) are "an inadequate defense because it essentially requires that we lose a measure of credibility before it can be invoked," he said.
"Our policy should strive to maintain the stability of inflation expectations," Lacker went on. "At times, this requires a preemptive tightening of monetary policy, before inflation expectations have deteriorated or inflation has surged."
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