RICHMOND, Va. — Reiterating his warnings about increasing inflation as the recovery proceeds, Richmond Federal Reserve Bank president Jeffrey Lacker Friday said the Fed must be careful to withdraw its monetary stimulus as the economy becomes “strong enough and well-enough established.”

Lacker, in remarks prepared for delivery to the Risk Management Association, said the Fed has the ability to either raise the rate of interest it pays on reserves or to drain reserves, but said the key is how and when to use its tools.

Lacker was fairly upbeat about the economy, pointing to increased activity in housing, consumer spending, business investment and in industrial production, as well as improvements in financial conditions.

But he said there are also “major economic challenges,” notably ongoing problems in commercial real estate and the labor market.

“Putting the whole picture together, I think the most likely outcome is that the economy will grow at a reasonable pace this year — housing should continue to recover from a very depressed state, consumers should gradually expand spending, business investment should make something of a comeback, and these components of demand should overcome a continuing drag from commercial construction,” Lacker said in a speech that largely reprised one he gave last week in Baltimore.

He said inventory rebuilding is already boosting production and anticipated that consumers’ spending will accelerate as they gain confidence, and businesses in turn will increase investment and hiring as the recovery goes on.

Against that backdrop, Lacker suggested the Fed needs to be increasingly wary of inflation risks.

With deflation risks having “diminished substantially,” Lacker said he hopes core inflation remains about 1.5% — what he called “a very good performance.”

But he warned: “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,” he said.

Monetary policy will play a crucial role in keeping inflation from accelerating, Lacker reiterated.

“What we will need to be careful about is when and how to withdraw the considerable monetary policy stimulus now in place,” he said. “This requires care during every recovery, but this time the Fed will have two monetary policy instruments at its disposal, not just one.”

“The Fed traditionally has targeted the overnight federal funds rate, which required appropriately adjusting the supply of monetary liabilities (currency and bank reserves),” he observed. “Varying the fed funds rate affected a broad range of other market interest rates, and thereby influenced growth and inflation.”

Noting that the Federal Reserve has had authority to pay interest on the reserve balances banks hold at the Fed since October 2008, Lacker said “this gives us the ability to vary independently the amount of our monetary liabilities and a critical overnight interest rate.”

— Market News International

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