WASHINGTON (MNI) – The following are excerpts from the speech by
Richmond Federal Reserve President Jeffrey Lacker Thursday in which he
says, “It may make sense, however, to begin normalizing our balance
sheet in advance of raising rates.”:

MONETARY POLICY

Certainly monetary policy will be challenging in the period that
lies ahead. Current policy settings are still at emergency levels, with
the federal funds rate near zero and with our balance sheet 2 and a half
times the size it was three years ago. These settings are currently
providing substantial monetary stimulus. As a technical matter, whenever
we decide to begin normalizing policy it will be straightforward to sell
assets, shrink our balance sheet, and raise the level of short-term
interest rates. The difficulty, of course, is that no one wants to
tighten policy prematurely and needlessly dampen the recovery. So
recognizing the right time to begin normalizing our monetary policy
settings is going to be hard, and reasonable people can differ about
this.

For my part, I will be looking for the time at which economic
growth is strong enough and well-enough established to warrant raising
our policy rate. It may make sense, however, to begin normalizing our
balance sheet in advance of raising rates. Normalizing our balance sheet
means reducing its size, but also returning to our traditional
Treasury-only asset holdings. My worry is that we will let the obvious
slack in the economy lull us into a false sense of security regarding
inflation, which could allow inflation pressures to build before we
raise rates. That happened in 2004 and it could happen again, so we at
the Fed will need to be careful to avoid waiting too long to raise
rates.

—

INFLATION

The economic picture would not be complete without some comment on
inflation. As recently as July, 2008, the 12-month inflation rate,
calculated from the price index for personal consumption expenditure,
was 4.5 percent. Of course the price of crude oil had just run up to
$140 a barrel that spring. But the core inflation index, which leaves
out food and energy prices, was 2.7 percent at that time, and to me even
that lower number was unacceptably high. That episode was one of several
unwelcome instances over the last decade of energy price surges spilling
over into core inflation. This pattern suggests that monetary
policymakers might need to reconsider the strategy of treating energy
price gains as by-gones if the futures curve is flat. Given the broad
upward trend in energy prices over the last decade, responding more
aggressively would have kept overall inflation lower and closer to a
rate I view as ideal.

Inflation has fallen since the surge of early 2008. In the last six
months, the overall inflation rate was 1.8 percent and the core
inflation rate was 1.1 percent. Those numbers are reasonable, and I
would be happy if inflation remains about where it is. But the public
expects to see higher inflation in the future. For example, the median
inflation expectation from the University of Michigan’s monthly survey
of consumer sentiment is 2.9 percent, and other surveys yield similarly
results. These readings on inflation expectations have been persistently
high, and that’s troubling, since they raise the possibility that people
think the FOMC will be unable or unwilling to conduct monetary policy in
a way that keeps inflation from rising significantly during this
recovery.

—

ECONOMIC OUTLOOK

To start with the big picture, we’re in the process of recovering
from a very severe recession, and despite the unique causes of the
contraction, this recovery resembles many that we’ve seen in the past.
Signs of strength are particularly notable in manufacturing, business
equipment investment, and consumer spending. As with other recoveries,
other segments of the economy are lagging behind the broad pickup in
activity, most notably employment and construction. Inflation has
remained quite moderate. The most likely scenario is for the recovery to
strengthen further in coming months.

—

But even though there are still weak patches in this recovering
economy, on balance, I believe consumer spending and business investment
are going to be strong enough to drive growth in overall activity.

BANKS

Still, we regularly hear complaints these days about firms being
unable to borrow. It is certainly true that there are banks and other
lenders who have experienced high losses and are now facing a higher
cost of capital. Those lenders are now reducing their outstanding loans,
and firms that have traditionally borrowed from these
capital-constrained lenders may have difficulty getting new loans or
even retaining existing credit lines. But the majority of banks appear
to be ready and eager to lend to creditworthy customers – that’s what
banking is all about. So while more borrowers may need to shop around in
this environment, I believe that credit market capacity is sufficient to
support productive investment and allow a solid recovery to proceed.

—

FISCAL POLICY

In broad terms, we all know what needs to be done – cut spending or
raise taxes. If we don’t, an adverse sequence of events will be set in
train: investors will be increasingly reluctant to hold more Treasury
securities, yields will consequently rise significantly, the cost of
capital will increase for firms producing in the United States, capital
formation will suffer, productivity growth will slow, and thus real
household incomes will stagnate. In short, the well-being of future
generations is at stake. My hope is that policymakers will find a way to
move fairly quickly to make the adjustments needed to put the budget on
a sustainable path. The sooner we make the necessary adjustments, the
longer the period over which we can spread out the adjustment cost, and
the more likely we are to avoid a fiscal crisis of the type Greece is
now experiencing.

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

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