WASHINGTON (MNI) – The following is the second of two sections of
the remarks of Federal Reserve Gov. Kevin Warsh prepared Monday for the
Atlanta Rotary Club:

Third, facts, not force, should be the predominant policy response.
Prevailing wisdom has it that policymakers must overreact when markets
do. In my view, this is an uncertain proposition. If a problem were
unique or isolated, game theory suggests that overwhelming force might
serve policymakers interests. But, these problems are not isolated. And
it is no game. Markets will continue to clamor for more explicit
government commitments. Better to feed the proverbial beast with more
facts than force. The Federal Reserve-led stress tests are but one
example where the balance was reasonably struck.

Fourth, there are no free lunches, but there is an early-bird
special for dinner. Economic trends–fiscal, monetary, trade, or
regulatory–tend not to improve when the immediate is continually given
preference over the important. The economys long-term growth prospects
must be given top billing. As economist Charles Schultze reminded us, it
is not the wolf at the door but the termites in the walls that require
attention.2 The sooner the house’s structure is strengthened, the
better.

A Way Forward

The job for policymakers, like business leaders, is not getting any
easier. There is an understandable tendency — amid an uncertain
environment–to defer the tough decisions. But, we might find framing
the policy choices–and confronting tough judgments — a prudent way
forward.

The most recent round of turmoil in financial markets caused many
fiscal authorities around the world to reconsider whether they can spend
their way to prosperity. Some are concluding that fiscal consolidation
may be the better path to economic expansion. That spending cuts are key
to establishing a credible path of fiscal sustainability. That
channeling government funds from higher-yielding private-sector
activities to lower-yielding public-sector activities undermines
economic potential. That fine-tuning aggregate demand requires a
precision that is difficult for governments to execute effectively. And,
that market forces are often more certain than promised fiscal spending
multipliers.

Fiscal policymakers must wrestle with difficult questions of
timing, external conditions, economic potential, and policy credibility.
Ultimately, in my view, fiscal consolidation happens either when
policymakers choose the path, or it gets chosen for them. The former is
preferred. The events in Europe remind us that the latter is likely if
policymakers do not act in a timely way.

(2 Charles L. Schultze (1989), “Of Wolves, Termites, and Pussycats:
Or, Why We Should Worry about the Budget Deficit,” Brookings Review,
vol. 7 (Summer), pp. 26-33.)

What About the Conduct of Monetary Policy?

The challenges for monetary policy are not dissimilar from those
confronting the fiscal authorities. The allure of short-term gains must
be balanced dispassionately against longer-term and potentially larger
consequences.

Last week, the FOMC announced that it would maintain the target
range for the federal funds rate at 0 to 1/4 percent, and it continues
to anticipate that economic conditions are likely to warrant
exceptionally low levels of the federal funds rate for an extended
period. The Fed announced no changes in the size or composition of its
balance sheet. However, the published minutes of recent FOMC meetings
make clear that the Committee has been carefully considering critical
aspects of its balance sheet policy. In my view, the Fed should pursue a
deliberate, well-communicated strategy that clearly differentiates the
path of the Feds policy rate from the size and composition of its
balance sheet. The Feds policy tools should not be conflated or
confused. One of the surviving features of the Feds extraordinary
actions is the breadth of tools at our disposal. They comprise a handy
set, and should remind us that every problem is not a nail. And that we
have more than the hammer in our toolkit. By considering, communicating,
and, potentially, deploying our policy tools independent of one another,
we have the best chance to achieve the Federal Reserves dual objectives
of price stability and maximum employment.

I consider the Feds policy rate–the federal funds rate–to be the
dominant tool in the conduct of operations going forward. It is far and
away the most powerful, its effects on the economy and financial markets
most clearly understood, and it is the most effective in communicating
our intentions. The Feds balance sheet of $2.3 trillion — of which
$1.6 trillion represents longterm Treasury securities, agency
mortgage-backed securities, and agency debt acquired since late 2008 —
should be considered, sized, and comprised independently of the policy
rate. In my view, the macroeconomic effects of these extraordinary
holdings are less significant, their effects on financial market
conditions less clear, and the markets understanding of our objectives
less understood than our dominant tool. Still, if federal fiscal policy
is approaching its political or economic limits, some believe that the
Federal Reserve should do more, including expansion of its balance
sheet.

In my view, any judgment to expand the balance sheet further should
be subject to strict scrutiny. I would want to be convinced that the
incremental macroeconomic benefits outweighed any costs owing to erosion
of market functioning, perceptions of monetizing indebtedness,
crowding-out of private buyers, or loss of central bank credibility. The
Feds institutional credibility is its most valuable asset, far more
consequential to macroeconomic performance than its holdings of
long-term Treasury securities or agency securities. That credibility
could be meaningfully undermined if we were to take actions that were
unlikely to yield clear and significant benefits. Indeed, the Federal
Reserve should continue to give careful consideration to the appropriate
size and composition of its existing holdings. Actual sales will not
take place in the near term. But, depending on the evolution of the
economy and financial markets, we should consider a gradual, prospective
exit — communicated well-in-advance — from our portfolio of
mortgage-backed securities. In making this judgment, we should continue
to assess investor demand for these assets. Ultimately, in my view,
gradual, predictable asset sales by the Fed should facilitate
improvements in mortgage finance and financial markets.

Any sale of assets need not signal that policy rates are soon
moving higher. Our policy tools can indeed be used independently. I
would note that the Fed successfully communicated and demonstrated its
ability to exit from most of its extraordinary liquidity facilities over
late 2009 and early 2010, even as it continued its policy of
extraordinary accommodation.

Conclusion

The United States is not Greece. We have the largest, most robust
economy in the world. We have the deepest, most liquid financial
markets. And the dollar is the world’s reserve currency, bestowing key
advantages upon us. But, none of this is our birthright. It must be
earned, and re-earned. The events of the past several years underscore
that unanticipated, nonlinear events can happen, even to the most
well-intentioned policymakers in the strongest economies in the world.
We ought not to be dismissive of the threats to our privileged position
in the world. And we should take the necessary measures to ensure that
our economy is strong over the long term.

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** Market News International Washington Bureau: 202-371-2121 **

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