NEW YORK – With two monetary policy instruments available to remove stimulus, Federal Reserve Bank of Richmond President Jeffrey Lacker said the how stimulus is removed will be as important as the when.
“What we will need to be careful about is when and how to withdraw the considerable monetary policy stimulus now in place,” Lacker told the Maryland Bankers Association today, according to prepared text of his remarks, which were released by the Fed. “This requires care during every recovery, but this time the Fed will have two monetary policy instruments at its disposal, not just one.” In addition to the feds fund rate, he added, the Fed can drain reserve balances.
“So when the time comes to withdraw monetary stimulus, the FOMC will be able to raise the interest rate on reserves or drain reserve balances, or both,” he said.
Price stability remains the core objective of monetary policy, Lacker reminded. “As always, that will require keeping inflation expectations anchored. Since those expectations reflect views about the future conduct of monetary policy, we will need to choose carefully when and how rapidly to remove monetary stimulus,” he said. “This is the same difficulty we face after every recession. For my part, I will be looking for the time at which economic growth is strong enough and well-enough established.”
As for inflation, Lacker, noted, “During the recovery period ahead we may face an increasing risk of inflation edging upward, which has sometimes occurred during past recoveries. While that risk appears to be minimal at this point, we will have to be careful as the recovery unfolds to keep inflation and inflation expectations from drifting around.”
The challenges remaining include the path of future federal budget deficits implied by current and planned fiscal policies, as well as financial regulatory reform.
“It should be self-evident that the government's debt cannot grow indefinitely at a rate much faster than the economy itself grows, as is implied by current law,” Lacker said. “Ultimately, something has got to change – either taxes are raised, spending is reduced, or the real value of the debt is eroded through inflation.”
Following the recent fiscal crisis, he added, “it makes sense to reexamine our approach to financial regulation. I have argued elsewhere that the most important step to ensuring long term financial stability is to establish clear and credible limits to the federal financial safety net – which has grown considerably as a result of the response to the crisis. I believe that the crisis itself was in no small measure the result of our not having clear limits on government support. Leverage and excessive risk-taking were encouraged by the belief that large parts of the financial system were implicitly protected, and those beliefs have been ratified. If we retain a stance of official ambiguity as to when such protection will or will not be forthcoming in the future, then I suspect our susceptibility to disruptive financial crises will continue to grow, and with each crisis, the safety net will become ever more expansive. A more expansive safety net will inevitably require more stringent regulation, but regulatory systems are necessarily limited in their capacity to completely offset the incentive distortions due to the safety net. So just like ambiguity about the path of future fiscal policies, continued ambiguity about the financial safety could limit our capacity for growth in the long run.”
