–Monetary Policy Should Do What It can For Recovery, But It Has Limits
–Current ‘Remarkably Unusual’ Econ Environ Warrants Highly Accomm Pol
–Economy Struggling To Gain Traction, Remains In The Grip Of Headwinds

By Brai Odion-Esene

WASHINGTON (MNI) – Cleveland Federal Reserve Bank President Sandra
Pianalto Tuesday said the central bank could have to take additional
steps to support the U.S. economy should the recovery grind to a halt
and prices threaten to come in “consistently below” the Fed’s explicit
target.

In remarks prepared for the Economic Research Institute of Erie,
Pennsylvania, Pianalto said monetary policy should do all it can to
support the recovery, but cautioned that there are limits to what it can
accomplish.

“Our recovery has been frustratingly slow. The economy is still
struggling to gain traction, and remains in the grip of headwinds
holding back stronger progress,” she said.

Pianalto is a voter on the Federal Open Market Committee this year.

Pianalto forecast economic activity to expand at a rate of around
2% in 2012, although she said reaching this “modest” level will require
some acceleration in growth in the second of the year.

“With this GDP growth forecast, my outlook includes a very slow
improvement in the jobless rate,” she said, adding, “Although I expect
the pace of GDP growth to pick up gradually through 2014, I anticipate
that unemployment will likely remain above 7% at the end of that year.”

This is nowhere close to the 6% unemployment rate that Pianalto
says is consistent with maximum employment for the U.S. economy “these
days.”

“If recent weak economic data persist and cause my outlook for
economic growth and inflation to become weaker than I currently
anticipate, additional policy actions could be warranted,” Pianalto
said.

She expects core inflation to remain near 2% over the next few
years due to slow economic and wage growth.

“Today’s highly accommodative policy is necessary for the economy
to make further progress on output and employment, and is consistent
with the Committee’s longer-run inflation objective,” Pianalto argued,
noting earlier in her remarks that “the remarkably unusual economic
environment we are in today calls for a highly accommodative monetary
policy.”

Still, while the Fed should do what it can to support the recovery,
there are limits to what policy can impact, she said.

“Monetary policy cannot directly control the unemployment rate; it
can only foster conditions in financial markets that are conducive to
growth and a lower unemployment rate,” Pianalto said, adding that “at
times, significant obstacles can get in the way.”

Echoing comments made by Fed Chairman Ben Bernanke during his
testimony earlier on Capitol Hill, Pianalto warned that the Fed cannot
solve Europe’s fiscal and banking problems, nor can it put U.S. fiscal
policy on a sustainable trajectory.

“As such, monetary policy cannot solve all of the economy’s
problems, especially in today’s highly uncertain environment,” she said.

She noted that much work remains to be done by European
authorities, and that financial conditions on the continent “remain
fragile and volatile.”

As for the U.S. fiscal situation, Pianalto cited challenges such as
the looming fiscal cliff, and the fact the government will once again
hit its borrowing limit. “There are reasons to think that these
potential fiscal challenges are already taking their toll on our
economy,” she said.

“Some business leaders I hear from have reported that they are
preparing for lost revenue from their government contracts, and are
taking proactive steps today to reduce their spending and hiring,” she
added.

If the Fed does decide to do more, Pianalto said there is “no
question” in her mind that additional large-scale asset purchases can
provide benefits “that are commonly attributed to them.”

“Research studies strongly support the conclusion that our
large-scale asset purchase programs have contributed to the decline in
interest rates,” she said. “Our large-scale asset purchases also have
the benefit of pushing back against deflationary pressures that can
emerge during periods of exceptional economic weakness. In doing so,
quantitative easing programs can help keep inflation from falling
persistently below our inflation objective.”

“We are using large-scale asset purchases as a policy tool in an
unusual financial and economic environment — one in which future
benefits may be more muted. Nonetheless, if warranted, further asset
purchases would have benefits,” she said.

Deploying these tools takes the Fed into unchartered territory, she
said, justifying more analysis.

Pianalto acknowledged some costs to such steps as well, noting a
further decline in rates could interfere with financial stability as
some banks — due to the low interest rate environment — and might take
actions to remain profitable that could affect financial system risk.

“It is also conceivable that, at some point, the Federal Reserve’s
presence in certain securities markets would become so large that it
would distort market functioning,” she said.

The Cleveland Fed chief said it would be helpful to have a better
understanding of how large the Fed’s participation would have to be to
cause a meaningful deterioration in securities market functioning, and
of the potential costs of such deterioration for the economy as a whole.

“For me, these are important issues since the effectiveness of the
quantitative easing approach requires that the asset purchases be of a
“large scale”; the initial large-scale asset purchase program totaled
$1.7 trillion and the second one amounted to $600 billion,” Pianalto
said.

** MNI Washington Bureau: 202-371-2121 **

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