The U.S. Federal Reserve will carefully evaluate economic forecasts to judge exactly when and how to exit out of its extraordinary rescue programs, and the withdrawal will happen “well before” inflation has a chance to rise out of control, the Fed’s vice chairman said Wednesday.
“We must begin to withdraw accommodation well before aggregate spending threatens to press against potential supply, and well before inflation as well as inflation expectations rise above levels consistent with price stability,” said Fed Vice Chairman Donald Kohn in a speech to the Cato Institute.
In a separate speech, the president of the Federal Reserve Bank of Atlanta said the Federal Reserve probably has a while longer to wait before it needs to start withdrawing its market support programs in earnest.
“I think it may well be some time before comprehensive exit need be under way,” Dennis Lockhart said in prepared remarks for a speech at an event hosted by the University of South Alabama’s Mitchell College of Business.
Mr. Kohn said there isn’t necessarily a list of variables that will trigger an exit. Instead, he pointed out that the Fed will base its decisions on economic forecasts, not current conditions. He added that he can’t predict the pace of rate increases.
“That too, depends on how the economy seems to be recovering and the outlook for inflation,” Mr. Kohn said. Mr. Kohn went on to outline the various tools the Fed has on hand to withdraw from its extraordinary programs and tighten monetary policy.
Though the U.S. economy is “unquestionably” improving, Mr. Lockhart recommended only “measured optimism” on the recovery in the economy and financial markets. Unemployment is likely to rise further above the current 9.7% before it falls; the residential housing market remains weak; and the commercial sector still poses a real threat, he said. The progress made so far has been achieved with considerable government and central bank stimulus, most of which remains in place.
His comments reinforced the view that the central bank will hold its target interest rate close to zero — where it’s been for the past nine months — well into next year.
“I would like to see more evidence of private activity in the economy before advocating change in the Fed’s overall monetary policy stance,” Mr. Lockhart said.
“The flow of credit through the U.S. banking system is not yet approaching anyone’s notion of normal,” he said.
Though banks have been repairing their balance sheets, “a return to robust bank lending is unlikely, at least in the near term.”
The banking sector hasn’t seen the last of the failures that have plagued it throughout this crisis, Mr. Lockhart said. In its efforts to continue covering losses incurred, the Federal Deposit Insurance Corporation has had to increase the fees paid by banks into its insurance fund.
“The normal pace of collecting fees from the banks…isn’t sufficient to bring the fund back to a healthy state,” Mr. Lockhart explained, responding to a question following his speech.
“As a general rule, I think we shouldn’t have excessive [government] intervention in the economy,” the central banker said, adding he has no insight into the internal deliberations of the FDIC.
But the pressure of around 90 bank failures so far this year has made the FDIC’s additional fundraising “a necessary evil.” Although he understands that the acceleration of fees is a burden to many in the banking sector, Mr. Lockhart said the FDIC’s approach “is a self-funding insurance policy for the country to ensure that the banking industry essentially covers much of its own losses.”
Mr. Lockhart singled out the continued deterioration of the commercial real-estate market as a “developing risk that could set back the progress being made by banks.”
He said commercial real-estate professionals at a recent Atlanta Fed conference believe that the worst may still be ahead for the sector.
Even the recuperation of the long-suffering residential property markets is fragile, and still depends heavily on the support of public programs, Mr. Lockhart said.
“There is too much uncertainty at the moment to project happy days almost here again.”
In response to another question, Mr. Lockhart said a decision on whether to extend a tax credit for first-time home buyers will have to wait on further data on the performance of the housing market overall.
The subsidy, which is due to expire at the end of November, “has shown results,” Mr. Lockhart said, and the impact, as is to be expected, has been on the lower-value end of the market.
This painstaking return to economic health should keep inflationary pressures in check, the central banker said, reminding his audience that the Fed is well aware of the risks it runs of a resurgence once the economy picks up, given its heavy subsidy of the financial system.
He reiterated his confidence that “the Fed has the tools to reverse the assumed monetary stimulus and exit the policies put in place in reaction to the financial crisis and recession.”
Mr. Lockhart is a voter this year on the Fed’s Open Market Committee, which last month opted to continue holding its target interest rate at the historic low of 0%-0.25% it hit in December. The FOMC also decided to extend its $1.25 trillion mortgage bond buying program into early 2010.
By Maya Jackson Randall and Emily Barret – wsj.com
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