UPDATE 2-Fed's Kohn: Balance sheet hasn't sparked spending

Thu May 13, 2010 2:25pm EDT

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By Louise Egan

OTTAWA May 13 (Reuters) - The U.S. Federal Reserve's massive addition of reserves to the banking system to combat the financial crisis should not be inflationary unless bank lending or inflation expectations jump, the Fed's No. 2 official said on Thursday.

Fed Vice Chairman Donald Kohn said although some believe that extra bank reserves could translate into additional borrowing and spending by businesses and consumers, that does not seem to have happened.

The large quantity of bank reserves are largely seen as a byproduct of extensive asset purchases by the Fed in an effort to boost the economy, Kohn said in a speech at Carleton University in Ottawa. The Fed's purchase of assets such as Treasuries was undertaken after the U.S. central bank cut interest rates to almost zero percent.

Policy makers viewed expanding reserves as unlikely to have an independent effect on financial markets and the economy, unless bank lending picked up, releasing those reserves into circulation, or if the sheer size of the balance sheet sparked inflation fears.

Kohn's comments reflect a debate between policy makers who worry the expanded balance sheet is a dangerous inflation risk as the economy recovers and those who think the economic convalescence is too sluggish to cause worry now about the volume of reserves.

Kohn noted that risk premiums for loans are still high, banks remain reluctant to lend, and reserves are not entering the financial system.

Bank behavior, however, could change as the economy recovers, and the Fed will have to monitor this situation carefully, he said.

The Fed must also carefully watch for evidence the enlarged Fed balance sheet is fueling any jump in anticipated inflation down the road, Kohn said.

"We need to be alert to the risk that households, businesses, and investors could begin to expect higher inflation based partly on an expanded central bank balance sheet," he said.

Central bankers lay great emphasis on keeping inflation expectations in check because they believe that if businesses and consumers anticipate higher inflation, they will adjust their buying and borrowing behavior. Keeping inflation expectations in check is viewed as a critical step to keeping inflation at bay.

STOPPING INFLATION

Kohn said the Fed has the ability to move quickly to stop inflation from taking hold once the recovery gets going. Raising interest on reserves would encourage banks to leave them on deposit with the Fed rather than putting them into circulation, he said.

"The ability to raise the interest rate on excess reserves will put upward pressure on interest rates and tighten financial conditions across the spectrum, so even with a lot of reserves in the system we'll be able to both drain reserves... and tighten conditions and stop any inflation from breaking out," he said in response to a question.

At its most recent policy-setting meeting in late April, the Fed renewed its promise to keep interest rates exceptionally low for an extended period as long as unemployment remains high and inflation and inflation expectations remain low.

Kohn stressed that the extended period promise is conditional and depends on the evolution of the economy.

After the Fed lowered interest rates to almost zero percent in December 2008, it began buying longer-term assets, including Treasuries and mortgage agency debt and mortgage-backed securities, worth $1.75 trillion.

Some Fed officials want the Fed to begin to pare its balance sheet sooner rather than wait for the recovery to be in full bloom because of what they perceive as inflation risks and the potential for future asset price bubbles. (Reporting by Louise Egan; Writing by Mark Felsenthal; Editing by Leslie Adler)

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