(Adds details, background)
By Louise Egan
OTTAWA May 13 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
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.
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)