By Steven K. Beckner

(MNI) – Far from helping the economy, the Federal Reserve’s
unconventional monetary stimulus measures have added to the more general
uncertainty about the outlook that is slowing the recovery, a top
economic advisor to Republican presidential nominee Mitt Romney said
Friday.

Stanford University Professor John Taylor, in an exclusive
interview with MNI, said the Fed’s large-scale asset purchases, by more
than tripling the size of the Fed’s balance sheet, will make it “hard”
for the Fed to tighten monetary policy to prevent inflation.

Taylor, who has been mentioned as a potential successor to Fed
Chairman Ben Bernanke if Romney is elected, said the Fed should have “a
strategy” or at least a “contingency plan” for reducing bank reserves —
not merely a set of reserve draining “tools.”

Reacting to Friday’s October employment report, Taylor observed
that, although better than expected, it was “consistent with sluggish
growth” and “still very disappointing.”

He contended the economy would grow faster under a Romney
administration due to a combination of tax reform, reduced government
regulation and other policies designed to remove business uncertainty
and incentivize hiring and investment.

Taylor, who served as Undersecretary of Treasury for International
Affairs in the George W. Bush administration, said that Romney, if
elected, would exercise more fiscal restraint than did Bush and would
also make an effort to roll back what he sees as excessive regulation.

He declined to say whether or not he thinks Fed Chairman Ben
Bernanke should be replaced, as Romney has said he would like to do.
Another top Romney advisor, Columbia University Professor Glenn Hubbard,
had taken a different tack in an earlier interview with MNI, saying
Romney should consider reappointing Bernanke.

When asked whether he would take the top Fed job if it was offered,
Taylor called that a “hypothetical question,” but said, “I just like
what I’m doing here” at Stanford. “I’ve been writing as much as I can
about this.”

If Romney does win the presidency, Taylor said “it’s going
to be tough” to deal with the United States’ economic and fiscal
problems.

Taylor was quite critical of the Bernanke Fed. He gave it credit
for some of its emergency liquidity measures during the crisis, for
example the special facility launched to ease strains in the commercial
paper market. But otherwise, he had little good to say about the conduct
of monetary policy in recent years.

He said the Fed helped cause the crisis by “keeping rates too low
too long” in the years leading up to the housing crisis in 2007 and
criticized the Fed’s “lack of clarity on interventions in early 2008.”

He said the Fed’s bail-out of Bear Stearns in March of that year
set up expectations of other bail-outs that were dashed when it let
Lehman Brothers go under six months later, exacerbating the financial
crisis.

Taylor was particularly critical of the Fed’s three rounds of
“quantitative easing,” including the ongoing $40 billion per month
“QE3.”

“I just think those have not been helpful,” he said. “In a way
they are part of the uncertainty more generally about policy.”

“Monetary policy has become part of that uncertainty,” he
continued. “People are concerned about how it’s going to be undone.”

Taylor said inflation has not yet accelerated, despite the Fed’s
monetary expansionism, for two main reasons: high unemployment and the
fact that “much of the expansion has been in the form of bank reserves,
not in terms of increases in the money supply itself”

“When either of those change then you will see the risk of
inflation,” he warned.

And Taylor said he is worried that “the Fed actions necessary to
contain (inflation) in that situation … are going to make policy more
difficult to operate.”

The Fed will have to reduce its nearly $3 trillion (and growing)
balance sheet at some point, and that will “requires selling some things
that have been purchased.” What’s more the Fed “will have to think about
raising the funds rate” and the rate of interest it pays on excess
reserves (IOER).

“Down the road I think monetary policy will be difficult to
operate,” he said. “That is another worry people have.”

Taylor, who has advised central banks around the world and has a
monetary policy rule named after him, was asked whether it will be
possible for the Fed to smoothly shrink its balance sheet and raise
interest rates when the time comes without disrupting the economy.

Bernanke and other Fed officials have often sought to reassure
financial markets that the Fed has the “tools” to “exit” from its
bloated balance sheet when the time comes. But Taylor said, “It will be
difficult, I don’t think there’s any question.”

“Getting a soft landing or, to put it another way, the appropriate
degree of tightening when required, is always difficult for central
bankers,” Taylor said, adding that the Fed “got it right” when it
preemptively raised the federal funds rate in the 1993-94 period.

“That worked very well,” he recalled. “It kept that expansion
going.”

“But it’s hard to do that,” he said, “and it will be even harder in
this situation.”

That is because Fed policymakers “don’t know exactly the impact of
selling the securities — it’s hard to estimate — and they don’t know
what the impact of reducing reserve balances will be on the banks.”

What’s more, “there is always uncertainty about (raising) the funds
rate and its impact on the economy,” Taylor continued. “So those will
all be there together.”

Taylor said the Fed could also find itself in a ticklish political
situation, because “you’ll have a situation where, when interest rates
have to go up in the future — and I do emphasize the future here — if
reserve balances are still high large payments will have to be made to
the banks.”

“And so in the environment that will exist it will be hard to do
it, and I think that’s why it’s not just the tools, it’s the strategy.”

Taylor said the Fed “should have a strategy for
this — not just the tools that are going to be used together.”

Philadelphia Federal Reserve Bank President Charles Plosser has
suggested that the Fed have a contingency plan for reducing reserves at
a certain pace, and Taylor said “something like that would be helpful
and would reduce the concerns that I have.”

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** MNI **

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