U.S. Fed balance sheet growth not inflationary-study

By Alister Bull

WASHINGTON, Sept 10 (Reuters) - The explosive growth in the U.S. Federal Reserve's balance sheet since last year will not automatically lead to higher inflation as some critics fear, a study released on Thursday found.

But there is an outside risk some of the central bank's credit easing measures to cushion the global financial crisis undermine its policy independence, according to the paper, which will be discussed later on Thursday by Fed Vice Chairman Donald Kohn.

Should the Fed lose so much money from market interventions that it requires U.S. government aid, the bank may be exposed to political pressure from Congress to keep rates low. Such a situation would lead to higher inflation, economist Ricardo Reis argues.

"Regardless of any other policy choice, interest-rate policy alone determines inflation," Reis said in his paper, discarding criticism the doubling in the Fed's balance sheet to around $2 trillion will eventually lead prices higher.

Called 'Interpreting the unconventional U.S. monetary policy of 2007-2009,' the study by the Columbia University economist examines the track record of the Fed a year after the failure of Lehman Brothers forced it to take unprecedented action to prevent a financial market meltdown.

The Fed deliberately grew its balance sheet to offset the collapse in demand for U.S. credit after Lehman's demise. It did so to stop the economy tipping into the type of deflation suffered in Japan, where falling prices led to a decade of stagnation.

This action has massively increased the level of reserves being held at the Fed by commercial banks. Critics fear this will lead to higher prices as the economy recovers, with banks turning to this cushion of reserves to ramp up lending.

Reis, agreeing with recent remarks from a number of Fed policy-makers, said the central bank's ability to pay interest on bank reserves would prevent this from happening.

"Once the Federal Reserve started paying interest on reserves ... the old money multiplier that linked reserves to the price level broke down." he said.

Reis' work also focused on Fed interventions in credit markets and concluded not all measures taken were wise.

In seeking to tame the financial crisis, the Fed invented a fleet of tools to ease credit conditions in specific markets, including lending for mortgages, consumers and small businesses.

Reis built a new capital markets model to review the effect of the Fed's different interventions on the availability of credit and got some mixed results, with credit shortages potentially developing in different points of the system.

"Looking back in a few years and using either the model in this paper or those that follow, some of the credit policies will be seen as ineffective or even harmful," he said.

Reis also argues that if the Fed winds up losing so much money from its market interventions that it needs to turn to the U.S. government for cash in order to remain operational, this would seriously harm its autonomy.

"Once transfers from the taxpayer to the Federal Reserve must be regularly approved by Congress, political pressure on the setting of interest rates is inevitable." Reis said. "There is a real danger that this will lead to a permanent increase in inflation in exchange for only a short-lived boost to output."

(Reporting by Alister Bull; Editing by Andrew Hay)