By Steven K. Beckner

PHILADELPHIA (MNI) – Philadelphia Federal Reserve Bank President
Charles Plosser warned Friday that, by buying mortgage-backed
securities, the Fed has “blurred the distinction” between monetary and
fiscal policy, risking both its independence and its commitment to price
stability.

Plosser, a voting member of the Fed’s policymaking Federal Open
Market Committee, deplored “increasing calls” for a softening of the
Fed’s commitment to price stability and warned that a failure to curb
mounting federal government debt could lead to an inflationary
“monetization” of the debt.

In remarks prepared for delivery to a Philadelphia Fed conference,
Plosser also said delays in reaching agreement on budget deficit
reduction is creating great business and household uncertainty that is
“detrimental” to economic growth.

The Fed is not currently buying MBS outright, as it did in its
first round of quantitative easing, but a number of Fed officials have
called for doing so, and Fed Chairman Ben Bernanke has said it is an
option.

At its September meeting, at which Plosser and two other Fed
presidents dissented, the FOMC instructed the New York Fed’s open market
trading desk to reinvest principal payments from its holdings of agency
debt and agency MBS in MBS, instead of in Treasury securities.
Simultaneously, in a so-called “Operation Twist,” the FOMC voted to buy
$400 billion of longer term Treasuries, financed by sale of short-term
Treasuries in the Fed’s portfolio.

Plosser said that action “could just as well have been conducted by
the U.S. Treasury.”

His broader point was that the Fed, like other central banks, has
been making “potentially dangerous” policy choices in a climate of
unrestrained deficit spending.

Mounting fiscal imbalances, he feared, could leading governments to
succumb to “the temptation of excessive money creation” and to abandon
their committment to price stability. The economic costs would be “quite
high,” he warned.

“Despite the well-known benefits of maintaining price stability,
there are increasing calls to abandon this commitment in both Europe and
the U.S.,” he said. “Central banks are under increasing pressure to act,
both because fiscal authorities have been unable to make credible
commitments to maintain fiscal discipline and because central banks have
been willing to engage in actions that stray into the realm of fiscal
policy — for example, purchasing assets of the housing sector.”

“This is a disturbing trend that risks undermining the independence
of the central bank to control monetary policy and its ability to
preserve a credible commitment to price stability,” he said.

Citing research by Nobel Prize winner Thomas Sargent, Plosser said,
“when the fiscal authority chooses an unsustainable fiscal policy path,
in which debt to GDP ratios are rising and proposed budgets don’t
generate enough future surplus to offset current deficits, seigniorage
is the only way for the government to achieve intertemporal budget
balance.”

“In other words, the central bank must eventually monetize the debt
— whereby high rates of inflation devalue longer-term government debt,”
he said. But he said such a strategy could backfire and lead to
uncontrolled inflation.

Although core inflation is now running a little under 2%, Plosser
said that may not last if the Fed is not careful.

“The continuing fiscal disarray may also lead the public to believe
that the government’s only near-term strategy is to monetize the debt,”
he said. “Even if the central bank resists, expectations of future
inflation could become unanchored and inflation could rise through no
fault or consequence of central bank action or intent.”

Plosser alleged that “the Fed and other central banks have already
embarked on a path that has blurred the distinction between monetary
policy and fiscal policy.” He cited MBS purchases, as well as the credit
facilities to support particular asset classes, such as commercial paper
and asset-backed securities, which the Fed established in November 2008
during the financial crisis.

“These types of credit programs target particular market sectors
and thereby alter the allocation of credit across markets, reducing
funding costs for some sectors and likely raising costs for others,” he
said. “These programs departed from the usual way the Fed implements
monetary policy through buying and selling U.S. Treasury securities, an
activity that is generally neutral across markets.”

“When the Fed engages in targeted credit programs that seek to
change the allocation of credit across markets, I believe it is engaging
in fiscal policy,” Plosser went on. “Instead of the central bank
engaging in this credit policy, the federal government could carry out
these transactions by issuing Treasury debt to support lending to the
targeted markets or firms … . Such credit allocation decisions belong
with the fiscal authorities, not the central bank.”

Plosser prefaced those remarks with disapproving commentary on the
political stalemate over agreeing on promised deficit reductions.

“These prolonged debates have detrimental effects on economic
growth, in part, because of the uncertainty they impose on consumers and
businesses,” he said, adding that people don’t know whether the
government will curb spending or increase taxes or some combination.

Plosser said higher taxes “would discourage both investment and
work effort.”

But “until the path is chosen, uncertainty encourages firms to
defer hiring and investment decisions and complicates the financial
planning of both individuals and firms,” he said. “The longer it takes
to reach a resolution on a credible plan to reduce future deficits, the
more damage is done to the economy in the near term.”

Plosser said a large component of the budget deficit is structural,
not just cyclical and noted that, in some countries, “market
participants have begun to question the solvency of governments and
their ability to honor their sovereign debt obligations.”

“In Europe, the doubts have greatly complicated the political
problems as various countries debate the question of ‘who pays’ for the
anticipated bad debts of individual countries,” he said. “Here too, the
protracted nature of the political debate creates uncertainty, which
undermines economic growth and exacerbates the crisis.”

In a paper presented at the conference, Indiana University Eric
Leeper warned that the United States and other countries are reaching or
have reached their “fiscal limit” — beyond which societies will be
unable or unwilling to support government spending programs and
entitlement commitments through ever higher levels of taxation.

At this “fiscal limit,” he said one option “allows the government
to fully honor its financial commitments, but requires the central bank
to give up control of inflation.”

The U.S, among others, “seem to have made no provisions whatsoever
for dealing with future fiscal stresses,” said Leeper. “In those
countries the public has no choice but to speculate about how future
policies will adjust.”

“Can expectations of inflation and interest rates be anchored by
monetary policy in this new policy realm?” he asked.

Leeper warned that “even if economic agents know how policies will
adjust once the economy hits the fiscal limit, it may no longer be
possible for monetary policy to achieve its inflation target.”

“Monetary policy’s loss of control of inflation begins well before
the fiscal limit is hit,” Leeper continued. “Because agents know such a
limit exists, monetary policy cannot control inflation even in the
period leading up to the limit.”

Leeper said the U.S. is “entering the period of enhanced fiscal
stress unprepared” amid “uncertainty about exactly how the government
will finance its obligations.”

** Market News International **

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