– Expanding Fed Balance Sheet Would Require ‘Strict Scrutiny’
– Eventual Asset Sales Need Not Mean Higher Fed Funds Rate
– ‘Differentiate’ Funds Rate, Balance Sheet Moves

By Steven K. Beckner

(MNI) – Federal Reserve Governor Kevin Warsh suggested Monday that,
if anything, the Fed should consider shrinking its balance sheet at some
point, though not now.

“Indeed, the Federal Reserve should continue to give careful
consideration to the appropriate size and composition of its existing
holdings,” he said.

“Actual sales will not take place in the near term,” he said. “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,” he added. “Ultimately, in my view, gradual,
predictable asset sales by the Fed should facilitate improvements in
mortgage finance and financial markets.”

In keeping with his approach of “differentiating” funds rate
changes and changes in the balance sheet, Warsh said, “Any sale of
assets need not signal that policy rates are soon moving higher.”

“Our policy tools can indeed be used independently,” he said. “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.”

Warsh echoed the FOMC in calling inflation “subdued” and inflation
expectations “stable.” But he later added a caveat: “Inflation
expectations may appear well anchored. But this is no guarantee of
future performance.”

“Market prices adjust slowly and steadily — until they don’t,” he
continued. “Then, market prices can act in a nonlinear fashion. That’s
when policymakers end up with fewer, less desirable options. And
economies are done harm.”

Warsh did not limit himself to talking about monetary policy. A day
after President Obama argued against moving too rapidly to reduce budget
deficits at the Group of 20 meeting, Warsh warned against undue delay in
returning to fiscal responsibility.

“Excessive growth in government spending is not the economy’s
salvation, but a principal foe,” he said. “The European sovereign debt
crisis is not upsetting the stability in financial markets; it is
demonstrating how far we remain from a sustainable equilibrium.”

“Turning private-sector liabilities into public-sector obligations
may effectively buy time, but it alone buys neither stability nor
prosperity over the horizon,” Warsh added.

Warsh appeared to cast doubt on the Keynesian fiscal precepts the
United States has been following in pointing to the fiscal policy
reversals that have been taking place in Europe since Greece required
emergency outside help to service its huge debts.

“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,” he observed, adding:

“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.”

“Ultimately, in my view, fiscal consolidation happens either when
policymakers choose the path, or it gets chosen for them,” Warsh said.
“The former is preferred. The events in Europe remind us that the latter
is likely if policymakers do not act in a timely way.”

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** Market News International **

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