By Steven K. Beckner

Continued:

The same is true on the flip side: unemployment could fall just
because of a dwindling labor force,” Lacker continued. “So … on both
sides you have the possibility of real errors if you focus too much on
the unemployment rate.”

Whether or not the FOMC decides to extend Operation Twist or
increase the size of QE3 to compensate for the expiration of the $45
billion monthly Twist purchases will depend on the FOMC majority’s
perception of “whether labor market conditions have improved
sufficiently,” he said.

Lacker said there should be no concern that the end of Operation
Twist will have significant upward “cliff effects” on bond yields.

“The economics are clear that the effect of our purchases (on
yields) depends on the stock of assets we hold and thus the public holds
at any one time,” he said. “I don’t see sharp changes in the flow of our
purchases being that disruptive.”

A decision to increase the size of QE3 is not something Lacker
would be likely to support, but if the FOMC does decide to do
so, he made clear his preference would be to buy Treasuries, not
more MBS.

He reiterated his longstanding position that it is
“inappropriate” for the Fed to “choose one sector over
another” and favor the mortgage credit market with MBS
purchases.

Aside from aggravating inflation risks, Lacker said the Fed is
making its longer run task of normalizing monetary policy more and more
complicated the longer it expands its balance sheet at a $40 billion per
month or larger pace.

“We’re clearly in uncharted territory with such a gigantic balance
sheet and the huge quantity of reserves we’re supplying to the banking
system,” he said.

“It seems highly likely that at some point we will need to
reverse course and reduce our balance sheet substantially, and when
that time comes the bigger our balance sheet the riskier that’s
going to be and the more sensitive outcomes are going to be to small
mistakes of judgment about when and how soon to withdraw stimulus.”

QE3 “will make exit that much tricker, that much more demanding,
that much riskier,” he added.

Bernanke and other Fed officials have expressed confidence that
the Fed can manage the exit by raising the rate of interest it pays on
excess reserves and other tools, but Lacker said those tools are
largely untested.

The IOER “has never been over 1%,” he noted. “We don’t know the
effect of our balance sheet on other interest rates….The IOER could
become decoupled from other interest rates.”

-more-

** MNI **

[TOPICS: M$U$$$,MFU$$$,MGU$$$,M$$CR$,MT$$$$,MMUFE$,M$$BR$]