At 4.30 pm on March 23, on a day dominated by release of the Obama administration’s plan to save the banking system and the fourth-best day in postwar Wall Street history, the US Treasury and Federal Reserve released a one-page joint statement on the division of economic responsibilities between the two agencies.
Amid the flurry of news, the statement passed with little public attention; neither the New York Times nor Wall Street Journal printed articles about it the next day. The release said that while the Fed collaborates with other agencies to preserve financial stability, it alone is in charge of keeping consumer prices stable, its independence “critical.”
The statement was the culmination of a behind-the-scenes, two-month long debate involving the Fed’s Open Market Committee, as well as the Treasury. The discussions were driven by Chairman Ben S Bernanke’s concern that work with the Bush and Obama administrations on repairing banks and markets not lead to attempts at political pressure later that would delay the start of measures to combat inflation.
“This is all about independence,” said Laurence Meyer, vice chairman of Macroeconomic Advisers LLC in Washington and a former Fed governor. “Even though the Fed is cozying up to the Treasury, it is important to know that the Fed would maintain some stability over monetary policy.”
JPMorgan Chase & Co analyst and former Fed economist Michael Feroli called the statement “The 2009 Treasury-Fed Accord,” harkening back to a joint announcement by the agencies in March 1951 that freed the central bank from pegging government-bond rates.
Fueling the debate is the concern that policy makers will have a tough time if they try to end their emergency-lending programs as soon as next year while the unemployment rate, currently a quarter-century high 8.1 per cent, remains at elevated levels.
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The risk is that, on the one hand, lawmakers and even some administration officials might balk at what they would see as premature steps, and on the other hand that any hesitation on the Fed’s part could spark inflation. Feroli said he gets frequent calls from clients worried consumer prices will surge as a result of the Fed’s record injections of reserves into the economy. After already more than doubling its balance sheet to $2.1 trillion, the Fed has pledged to buy $1.25 trillion of mortgage-debt and $300 billion of Treasuries, and finance a $1 trillion consumer-loan program.
Fed district-bank presidents Jeffrey Lacker of Richmond and Charles Plosser of Philadelphia have been among the most outspoken sitting officials to warn about diverting the central bank’s mission.
Plosser said in a Feb. 27 speech that “an accord to substitute Treasuries for non-Treasury debt on our balance sheet would” help the central bank better implement monetary policy. It would allow pulling back on liquidity injections with “minimal concerns about disrupting particular credit allocations or the pressures from special interests,” he said.
Lacker Dissent
On March 2, Lacker said that an accord with the Treasury “could stipulate that the emergency lending is transferred to the books of the Treasury after a brief period of time has elapsed.” In January, he voted against an FOMC’s commitment to buy mortgage debt and finance securities backed by consumer loans, preferring instead to purchase Treasuries.
The agreement between the Fed and Treasury last week included a pledge that “in the longer term and as its authorities permit, the Treasury will seek to remove from the Federal Reserve’s balance sheet, or to liquidate” the assets the central bank has acquired from rescues of Bear Stearns Cos. and American International Group Inc.
Treasury Secretary Timothy Geithner, a former president of the Federal Reserve Bank of New York, said yesterday that the Fed’s injections of reserves into the economy are “not going to create the risk of hyperinflation in the future.”
Brake ‘Too Quickly’,BR> “We have a strong independent Federal Reserve with a very strong mandate from the Congress, and they will do what’s necessary to keep inflation low and stable over time,” Geithner said on ABC television’s “This Week with George Stephanopoulos.” At the same time, he warned that policy makers shouldn’t “put the brakes on too quickly.”
One lesson from the Great Depression was that in the late 1930s, officials acted too early in pulling back on stimulus measures, the Treasury secretary said.
Some investors worry that the Fed will be too slow.
“I don’t think there is a chance that we can have low inflation coming out of this,” said Axel Merk, manager of the $300 million Merk Hard Currency Fund. “All this money is going to stick at some point.”
Meltzer cites a 1979 lecture by Arthur Burns, who ran the Fed from 1970 to 1978, as an example of how the political climate can influence central bankers. Burns oversaw a surge in the U.S. inflation rate to 12.3 percent in 1974 from 5.6 percent in 1970.
Burns’s Inflation
“‘Maximum’ or ‘full employment,’ after all, had become the nation’s major economic goal -- not stability of the price level,” Burns wrote, while noting that politicians didn’t support an inflation fight.
Only days after Burns’s lecture, then Fed chairman Paul Volcker launched an attack against inflation, dispensing with political concerns about the economic cost.
By March 1980, when consumer prices rose almost 15 percent, Volcker engineered a tightening in monetary policy that drove the benchmark rate to 20 percent. The step sent the economy into a recession and caused unemployment to climb. By December 1982, consumer-price gains had slowed to just 3.8 percent, at the cost of a 16-month recession.
President Ronald Reagan replaced Volcker with Alan Greenspan in 1987. Bernanke’s term is due in January 2010.
No congressional leader is calling for the Fed to ignore inflation today. Still, the Fed-Treasury statement specified the central bank shouldn’t “allocate credit to narrowly defined sectors or classes of borrowers,” providing a door to exit from aid to specific markets in the future.
Fed Bills
To help raise rates when the time comes, the Fed wants the power to sell its own debt as a means of mopping up some of the funds it’s pumped into the economy. San Francisco Fed President Janet Yellen said last week: “I would feel happier having it now.”
Yellen noted that there are other steps the Fed could take. One option would be long-term reverse repurchase agreements, where the central bank borrows cash from Wall Street dealers, putting its mortgage-debt holdings up as collateral.
“Every single member of the FOMC is right on top of this, including Bernanke,” said Ethan Harris, co-head of U.S. economic research at Barclays Capital Inc. in New York. “The problem is they are spilling over into credit allocations; they are risking Congress stepping in.”