From the desk of:

Rich Storey
Mortgage Advisor
615-260-8028


Tightening Credit Becomes Bernanke Bind in Bond Purchase Unwind
By Yalman Onaran

July 24 (Bloomberg) -- Now that the U.S. economy shows tentative signs of recovery, James Bullard, president of the Federal Reserve Bank of St. Louis, wants the Fed to adopt a plan for taming the inflation he expects may follow the end of the recession. Unless the central bank puts a strategy in place and presents it to the public, inflation expectations may run rampant, Bullard says.

He’s pessimistic such a plan will be forthcoming. “I think I’m an army of one on that,” Bullard said in an interview after a speech in Philadelphia on June 30.

The Fed always faces a hard choice as recessions run their course (this one began in December 2007): It can keep pushing to revive growth and avoid deflation -- an extended drop in prices like the one that devastated the U.S. economy in the early 1930s -- or it can take aim at inflation and risk strangling the recovery before it takes hold.

The unprecedented steps the central bank has taken to battle the credit crunch, especially its purchases of mortgage- backed securities, pose an inflation risk that’s trickier than in previous recessions, says Joseph Mason, a banking professor at Louisiana State University in Baton Rouge, Louisiana.

Don’t count on the Fed to get it right, says economist Allan Meltzer of Carnegie Mellon University in Pittsburgh. The central bank has often lacked the resolve to pursue unpopular policies to keep prices in check, says Meltzer, who’s the author of two volumes chronicling the Fed from 1913 to 1986.

“The Fed throughout its history has carried out a strategy of taking care of today’s problems, not looking to the future,” Meltzer says.

Great Depression

So far, inflation has shown no signs of heating up -- nor has deflation reared its head. The U.S. core inflation rate, which excludes food and energy costs, fell to 1.7 percent as of June from 2.4 percent at the beginning of the recession. In the Great Depression, consumer prices fell for more than three years, at an annual pace as high as 10 percent.

Federal Reserve Chairman Ben S. Bernanke, who has published academic research on the Depression’s causes, is wary. He said in June that the Fed continues to watch for deflation, and he testified to Congress this week that the economy still needs support to recover, especially in light of rising unemployment. The central bank has the tools it needs to reverse its monetary easing when it’s time to fight inflation, he said.

Among the Fed governors and reserve bank presidents who oversee monetary policy, most see slow growth and deflation as a bigger risk than inflation, based on speeches they have delivered in recent months.

Fed Balance Sheet

Bullard, among the minority worrying more about inflation, says the real risk is simmering on the central bank’s balance sheet. By making loans and buying securities to unfreeze the credit markets, the Fed has doubled its balance sheet assets to $2 trillion in the past year.

About half of that expansion came through short-term lending to financial institutions. The Fed is scaling back those facilities. It’s the rest of the balance sheet growth that concerns Bullard -- especially $661 billion of MBSs acquired to push down rates on home loans. The Fed has said it may buy as much as $589 billion more.

“I call those the politically toxic assets,” says Benn Steil, a senior fellow at the Council on Foreign Relations in New York. Selling those bonds would boost home buyers’ borrowing costs and stall the recovery of the housing market.

Lender Reserves

Traditionally, the work of a central banker has been simpler: lower your benchmark rate to counter a recession and raise it when the economy recovers to prevent inflation. The current crisis shows the limits of that approach. Even after the U.S. federal funds rate was cut to zero late last year, the economic slide worsened. U.S. gross domestic product fell at a 5.5 percent annual rate in the first quarter of 2009. Bernanke responded with the loans and the purchases of MBSs, an approach known as quantitative easing.

One way to counteract the easy credit the Fed has created might be to raise the interest rate on the reserves that lenders hold at the central bank, Bernanke says. U.S. financial institutions had $781 billion of such reserves as of this week, up from just $32 billion in September 2008. The central bank got authority in October to pay interest on those funds. It has been paying 0.25 percent and can change the rate at any time.

Banks will withdraw this money when they feel it’s safe and profitable to make loans. By paying higher interest, the Fed would make it less attractive for banks to pull that money out and pump it into the economy.

Untested

There’s little precedent for managing the money supply with interest on reserves, so it may be impossible to figure out where to set the rates. “We don’t know what a percentage point change in the interest rate on reserves will do to lending by banks,” says Mason at Louisiana State.

Meltzer is skeptical that Fed policy makers will act, even if they figure out how. In the 1960s and 1970s when inflation was rising, the Fed set out goals to fight it at least four times only to back down under political pressure. Paul Volcker, who became Fed chairman in 1979, was the exception. He ignored politicians and pushed the benchmark fed funds rate as high as 20 percent in the early 1980s.

Central bankers tilt toward stimulating growth, Meltzer says, partly because Depression-era deflation is imprinted on their minds, while periods of deflation prior to the 1930s that didn’t wreak havoc are forgotten.

The perception that a central bank won’t move against rising prices can actually contribute to inflation, says William Silber, a professor at New York University. When the public expects inflation, it’s easier for retailers to raise prices and for workers to demand wage increases, he says.

Stagflation

Silber is writing a book about Volcker’s fight against inflation in the 1970s, when prices rose even during recessions. The public’s view that there was a lack of will to fight inflation helped cause this phenomenon, known as stagflation.

This is one reason Bullard wants the Fed to actually publish a plan for tackling inflation and not just draft it for internal purposes. To contain inflation, the battle often needs to begin before it’s visible -- never a politically pleasant task. Acting now promises to be especially unpalatable, with unemployment at 9.5 percent in June and home foreclosures coming at a record pace in the first half of this year.

Credited to: www.Bloomberg.com