NEW YORK – Monetary policy and the Fed’s balance sheet are distinct tools in the Fed’s arsenal and “should not be conflated or confused,” Federal Reserve Board Governor Kevin Warsh said today.
“In my view, the Fed should pursue a deliberate, well-communicated strategy that clearly differentiates the path of the Fed's policy rate from the size and composition of its balance sheet,” Warsh told the Atlanta Rotary Club today, according to prepared text released by the Fed. “The Fed's policy tools should not be conflated or confused.”
Warsh said the Fed has many tools that can be used in different situations. “By considering, communicating, and, potentially, deploying our policy tools independent of one another, we have the best chance to achieve the Federal Reserve's dual objectives of price stability and maximum employment.”
The federal funds rate, he said, is the “dominant tool in the conduct of operations going forward. It is far and away the most powerful, its effects on the economy and financial markets most clearly understood, and it is the most effective in communicating our intentions.”
The Fed's balance sheet “should be considered, sized, and comprised independently of the policy rate. In my view, the macroeconomic effects of these extraordinary holdings are less significant, their effects on financial market conditions less clear, and the markets' understanding of our objectives less understood than our dominant tool.”
Should the Fed need to further expand its balance sheet, there needs to be “strict scrutiny,” he said. The incremental macroeconomic benefits need to outweigh “any costs owing to erosion of market functioning, perceptions of monetizing indebtedness, crowding-out of private buyers, or loss of central bank credibility. The Fed's institutional credibility is its most valuable asset, far more consequential to macroeconomic performance than its holdings of long-term Treasury securities or agency securities. That credibility could be meaningfully undermined if we were to take actions that were unlikely to yield clear and significant benefits.”
While he does not foresees actual sales in the near-term, Warsh said, the Fed “should continue to give careful consideration to the appropriate size and composition of its existing holdings.” He backs a “gradual, prospective exit - communicated well-in-advance - from our portfolio of mortgage-backed securities,” while continuing to assess investor demand for these assets. “Ultimately, in my view, gradual, predictable asset sales by the Fed should facilitate improvements in mortgage finance and financial markets.”
But, he added, “any sale of assets need not signal that policy rates are soon moving higher. Our policy tools can indeed be used independently. I would note that the Fed successfully communicated and demonstrated its ability to exit from most of its extraordinary liquidity facilities over late 2009 and early 2010, even as it continued its policy of extraordinary accommodation.”
Virtually all assets globally were mispriced, not just subprime mortgages, and that was the cause of the financial crisis, with financial market volatility a sign of the times, which has left financial conditions “less supportive of economic growth,” Warsh said.
“Too-big-to-fail exacerbated the global financial crisis, and remains its troubling legacy,” Warsh added. “Excessive growth in government spending is not the economy's salvation, but a principal foe. Slowing the creep of protectionism is no small accomplishment, but it is not the equal of meaningful expansion of trade and investment opportunities to enhance global growth. The European sovereign debt crisis is not upsetting the stability in financial markets; it is demonstrating how far we remain from a sustainable equilibrium. Turning private-sector liabilities into public-sector obligations may effectively buy time, but it alone buys neither stability nor prosperity over the horizon.”
He added, “a moderate cyclical recovery characterizes the last several quarters in the United States. But while the recovery is proceeding, investors remain uncertain about its trajectory. Financial market participants are still searching--perhaps better characterized as lurching--for a new equilibrium.”
Where will the economy go? Warsh said it “depends in part on whether a new market and public policy equilibrium is established to keep the financial repair process on track. If volatility in financial markets persists at elevated levels, the expected pickup of business fixed investment may disappoint. Business leaders in the United States may react to the latest in a long series of shocks by postponing investments in capital and labor alike. In that way, massive excess cash balances might not be a source of strength, but a reminder of caution.”
But, if volatility abates, “the economic recovery should continue apace. Businesses and consumers would then be better positioned to convert the recovery into a more durable expansion.”
