Yellen: Fed Balance Sheet Not Spurring Inflation

The Federal Reserve’s expanded balance sheet won’t create high inflation, according to Federal Reserve Bank of San Francisco president and chief executive officer Janet Yellen, because current economic conditions require increased demand.

“Monetary policy fosters inflation when it loosens the stance of policy enough to create excess demand for goods and services,” Yellen told bankers in Idaho yesterday, according to prepared text of her remarks released by the Fed. “Right now, we have exactly the opposite — an excess supply of goods and services. We need more demand — not less — to offset slack in labor and product markets.”

Additionally, she said, wages have grown slowly, or been cut, forcing businesses to slash prices, which has in turn pushed core inflation below 2%.

“With unemployment already substantial and likely to rise further, and industrial capacity utilization at record low levels, downward pressure on wages and prices isn’t likely to go away soon,” Yellen warned. “I expect core inflation to remain below 2% for several more years.”

However, she said, when the economy starts to recover, monetary policy will have to be tightened or else it will lead to higher inflation. “We have the tools to tighten policy when the time is right and we have the will to use them,” she said.

In addition to a “tapering off” in the use of emergency programs, which is reducing the Fed’s balance sheet, Yellen said many of its assets — including Treasury and mortgage-backed agency securities — can be sold easily. Also, the Fed can use the federal funds rate hike in the interest rate on reserves, which “will induce banks to lend money to us rather than to other banks, thereby pushing up rates in the interbank market and, by extension, other interest rates throughout the economy.”

She added: “This is an important tool because, even if the economy rebounds nicely, the credit crunch might not be fully behind us and some financial markets might still need Fed support. This tool will enable us to tighten credit conditions even if we maintain a large balance sheet for a time.”

Turning to programs, which she called “alphabet soup” that caused some grumbling, Yellen said, “Those initiatives may not have been perfect, but I believe they succeeded in supporting the system until a measure of confidence returned.” She said stimulus programs weren’t “designed to produce an economic recovery” as much as to “cushion our fall. In that sense, it’s doing its job.”

She warned that recovery “is likely to be painfully slow,” and while recovery seemed to be starting, “there remains some chance that economic conditions could turn out worse than what I’ve sketched. High on my worry list is the possibility of another shock to the still-fragile financial system. Commercial real estate is a particular danger zone.”

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