– 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 warned Monday that if
financial conditions continue to be volatile and “less supportive” of
growth, the economy could suffer and said the recovery would benefit if
volatility lessens.

Warsh said further expanding the Fed’s balance sheet to aid the
economy, now that the Fed can no longer lower the federal funds rate,
would require “strict scrutiny.” Buying more assets without clear
benefit to the economy would endanger the Fed’s “credibility,” he
cautioned.

Asset sales are not likely in the near term, but when the Fed
eventually sheds some of its assets to shrink its bloated balance sheet,
they need not necessarily lead to an increase in the funds rate, Warsh
said.

He said the Fed must “differentiate” its “dominant” federal funds
rate tool from management of its balance sheet.

Warsh’s comments in a speech to the Atlanta Rotary Club were the
first by a senior Fed official since the central bank’s policymaking
Federal Open Market Committee met last week and left the funds rate
target between zero and 25 basis points, while reiterating its
expectation that the rate will stay “exceptionally low…for an extended
period.”

In explaining its decision last Wednesday afternoon, the FOMC
observed that “financial conditions have become less supportive of
economic growth on balance, largely reflecting developments abroad” —
an obvious reference to the impact of the European debt crisis.

Warsh echoed the FOMC statement and elaborated on just what the
FOMC meant by “less supportive” financial conditions.

“In early May, concerns intensified regarding fiscal difficulties
in some European countries,” he explained in prepared remarks.
“Financial market volatility resurfaced with a vengeance in U.S.
markets. The implied volatility of equity prices (VIX) jumped to levels
not seen in more than a year.”

“In short-term funding markets, spreads between the Libor (London
interbank offered rate) and the OIS (overnight indexed swap) rate
widened and commercial paper rates for many issuers jumped,” Warsh
continued. “Investors became decidedly less willing to provide funds at
longer tenors.”

Warsh also noted that “Treasury yields fell to near historic lows,
in part as investors sought refuge in dollar-denominated, highly liquid,
safe-haven assets.” And he noted that “equity prices, reacting to
increased risk and prospects for weaker global growth, also fell.”

“Broad equity price indexes touched lows as much as 14% below their
recent peak in April,” he went on. “And retail investors may have
experienced one scare too many; outflows from equity mutual funds appear
to rival the retreat in late 2008.”

Warsh added that “risk spreads on U.S. investment-grade and high
yield bond prices rose, and corporate bond issuance fell to about half
the run-rate of earlier this year. Broad measures of industrial
commodity prices decreased substantially from their peaks–mostly on
account of weaker expected global demand.”

Warsh also echoed the FOMC’s expressions of concern about weakness
in the labor market, but was even more emphatic, saying, “employers
appear quite reluctant to add to payrolls.” (The FOMC omitted the word
“quite”).

While saying the U.S. is undergoing “a moderate cyclical recovery,”
Warsh expressed doubt about its strength and sustainability.

“But while the recovery is proceeding, investors remain uncertain
about its trajectory,” he said. “Financial market participants are still
searching–perhaps better characterized as lurching–for a new
equilibrium.”

“The economy’s path depends in part on whether a new market and
public policy equilibrium is established to keep the financial repair
process on track,” he continued. “If volatility in financial markets
persists at elevated levels, the expected pickup of business fixed
investment may disappoint.”

Warsh warned that “business leaders in the United States may react
to the latest in a long series of shocks by postponing investments in
capital and labor alike. In that way, massive excess cash balances might
not be a source of strength, but a reminder of caution.”

“If, however, volatility levels across asset markets
abate–indicating that the financial repair process is continuing–the
economic recovery should continue apace,” he said. “Businesses and
consumers would then be better positioned to convert the recovery into a
more durable expansion.”

In setting monetary policy going forward, Warsh said, “the allure
of short-term gains must be balanced dispassionately against longer-term
and potentially larger consequences.”

Although the FOMC announced no changes in the size or composition
of its balance sheet last week, Warsh observed that “the published
minutes of recent FOMC meetings make clear that the Committee has been
carefully considering critical aspects of its balance sheet policy.”

He said “the Fed should pursue a deliberate, well-communicated
strategy that clearly differentiates the path of the Fed’s policy rate
from the size and composition of its balance sheet. The Fed’s policy
tools should not be conflated or confused.”

Warsh said the Fed has a “breadth of tools at our disposal” that
can be used selectively. Remarking that “every problem is not a nail,”
he observed, “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 Reserve’s dual objectives of price stability and
maximum employment,” he added.

Warsh said he considers the federal funds rate “the dominant tool
in the conduct of operations going forward” because “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.”

As for the Fed’s $2.3 trillion balance sheet, which contains $1.6
trillion long-term Treasury securities, agency mortgage-backed
securities, and agency debt acquired since late 2008, Warsh said it
“should be considered, sized, and comprised independently of the policy
rate.”

Warsh said, “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.”

Nevertheless, he noted that “some believe that the Federal Reserve
should do more, including expansion of its balance sheet.”

Warsh didn’t rule out buying more assets, but said he believes “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,” he said.

“The Fed’s institutional credibility is its most valuable asset,
far more consequential to macroeconomic performance than its holdings of
long-term Treasury securities or agency securities,” he continued. “That
credibility could be meaningfully undermined if we were to take actions
that were unlikely to yield clear and significant benefits.”

-more-

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