CHARLESTON, South Carolina (Reuters) - The Federal Reserve must not ignore inflation as it battles the U.S. recession, a top Fed policy-maker said on Thursday, saying also that clarifying banks’ capital needs was more important than removing their bad debts.
“Such a large increase in the monetary base cannot be left in place indefinitely without creating quite sizable inflation pressures,” Richmond Federal Reserve President Jeffrey Lacker told an audience of local business leaders in Charleston.
“Choosing the right time to withdraw that stimulus will be a challenge and I believe it will be very important to avoid the risk of waiting too long,” said Lacker, who is a voting member of the Fed’s policy-setting committee this year.
Lacker also said that when it came to restoring confidence to financial markets, a stress-test of the country’s top lenders, to be completed next month, may be more important than the effort to cleanse toxic assets from bank balance sheets.
He told reporters that it was not clear how many bad assets would actually be moved from bank balance sheets to public-private investment programs announced on Monday.
But he did not think the scale of the toxic asset plan was the right way to gauge whether it would restore confidence in the banking system after the worst financial crisis since the Great Depression.
“I’m not sure our success...will depend on how much flows into this...I think it depends on the success of the stress tests,” he told the reporters.
The top 19 U.S. banks are being subjected to a tough assessment of how their capital buffers will stand up if the economy turns out to be even weaker than expected.
Lacker said this would help clarify how much more capital they will need and answer questions about further government intervention to prop up the ones in the worst shape, paving the way for private investment as that threat recedes.
“We are not going to get through this crisis...until markets believe the problem of further capital injections by government is nil...The stress-testing exercise is the most important part of it,” he earlier told students during remarks at the College of Charleston.
The Fed, which has already cut interest rates almost to zero, last week announced it would buy up to $300 billion of longer-dated Treasury securities and an additional $850 billion of agency mortgage debt to help offset a deepening recession. This comes on top of a more than doubling in the Fed’s balance sheet to almost $2 trillion since September.
“I am confident that we can prevent outright deflation by expanding our monetary policy stimulus if need be. But at the same time, it is not premature to be concerned with the behavior of inflation when the recession is over and the recovery has begun,” he said in the speech.
Lacker said he voted for this powerful stimulus because some economic data since the previous meeting in January had been worse than he had expected, and because the U.S. monetary base contracted by around $200 billion over that period.
“I thought it was important to step up the level of stimulus we were providing,” he told reporters.
The decision for the Fed to buy longer-dated Treasuries was one that Lacker had lobbied for and he had dissented at a Fed meeting in January in favor of this approach.
It was also a pure monetary policy action, he said, and different from credit market interventions also undertaken by the Fed in recent months to aid financial sectors that appeared to be broken, which he called more like fiscal policy.
“The good news right now is that credit and monetary views yield complementary policy implications, because policies that provide targeted Fed credit also add reserves to the monetary base,” he said. “The more difficult choices will come down the road, if improvements in credit conditions and the overall economy do not coincide.”
Lacker told the reporters that he welcomed a joint statement from the Fed Board of Governors in Washington and U.S. Treasury on Monday to clarify the Fed’s role in protecting financial and monetary stability.
But he said it could have been more specific in distancing the Fed from influencing credit allocation within the economy, and cited its current support for the commercial paper market.
It was not all doom and gloom. Highlighting increases in U.S. retail sales, lower gasoline prices and steady wages, Lacker said he thought it reasonable to expect the economy to turn the corner later this year and begin a gradual recovery.
“This may be a sign that consumers are responding in the manner suggested by economic theory and basing their immediate consumption plans on less adverse longer-run income prospects. This is a key element in the case for the economy bottoming out this year,” he said in the speech.
Reporting by Alister Bull, Editing by Chizu Nomiyama