NEW YORK (Reuters) - The Federal Reserve must be careful about taking on credit risks as it broadens its new consumer lending program, even though a “pretty ugly” economic outlook warrants aggressive action, a top Fed official said on Thursday.
Philadelphia Federal Reserve Bank President Charles Plosser told Reuters the U.S. central bank needs to expand its balance sheet to combat the recession, but he said it was hard to tell how much money policy-makers should pump into the economy.
“We do need to expand the balance sheet, though there is a discussion about how much is enough. We’re in uncharted territory so this is an issue a lot of us are grappling with,” Plosser said in the interview.
In an aggressive bid to battle a deep recession, the U.S. central bank last week vowed to provide the economy with an additional $1.15 trillion, partly by buying government bonds for the first time since the 1960s.
The Fed also said it would expand purchases of debt and securities issued by mortgage finance agencies in an effort to lower mortgage rates.
Some financial markets participants fear the Fed’s aggressive actions to support the economy, which have made its balance sheet more than double to over $2 trillion since the beginning of the crisis, will fire up inflation when the economy eventually recovers.
Plosser said it was not so much the size of the balance sheet that troubled him as its composition, and he voiced support for buying Treasury bonds.
Plosser, considered a hawk on inflation, said buying longer-term government debt will give the Fed more flexibility when the time comes to unwind its non-traditional policies. He noted they are also “more neutral in their effects on the allocation of credit” than a number of other Fed programs.
In the interview, he reiterated a warning that targeting specific markets, such as mortgage-backed securities, could open the Fed up to political pressure when the time comes for the central bank to remove its support.
Plosser said he was not as worried about the risk of deflation “as some people,” and noted that inflation expectations had remained “pretty stable.”
Still, he said it was appropriate to tamp down any risk.
“Expanding the balance sheet ends up providing a couple of advantages, helping support the economy and ensuring deflation doesn’t become an issue,” Plosser said.
The Philadelphia Fed chief, who is not currently a voter on the central bank’s policy-setting panel, said he was not worried about “ballooning inflation anytime within the next months or even quarters.”
“We are talking a year or two away, at least, before you begin to worry too much,” he said.
But he said a debate on how the Fed should shrink its balance sheet in a timely way has to happen long before inflation rears its head.
He said that there had been discussion of going to Congress to seek authority for the Fed to issue its own debt, which could be used to help shrink its balance sheet, but he would prefer to remove liquidity in a more “traditional fashion.”
“There are arguments for Fed bills, I don’t want to rule that out,” he said. “But I’d probably prefer the supplementary Treasury account if we needed more tools,” referring to a program under which the Treasury issues debt on the Fed’s behalf.
Plosser, who last month suggested the Treasury should remove some of the risk from the Fed’s balance sheet to avoid its independence being compromised, said he was heartened by an unusual joint statement from the Fed and the Treasury on Monday, which underscored that the Fed should focus on monetary policy.
“It didn’t really outline the details, but you have to start with some important principles,” he said.
In the statement, the Fed and Treasury said that despite the recent wave of unconventional moves to help stabilize the economy, the Federal Reserve must maintain its independence and focus on the stability of the economy as a whole, rather than specific sectors or types of institutions.
As part of the massive U.S. efforts to revive the economy, the Treasury on Monday announced the expansion of the Fed’s Term Asset Backed Securities Lending Facility (TALF) to include older assets, a move that could expose the Fed to credit risk, Plosser said. With TALF, the Fed aims to revive consumer and small business lending.
“There are risks associated with expanding the TALF too broadly, particularly with these legacy assets,” Plosser said. “But a lot depends on how it ends up being managed. It remains to be seen until we work out the details how much credit risk there will be.”
The expansion of the TALF to include older assets comes as part of a government plan to cleanse bank balance sheets of so-called toxic assets.
Plosser said he was heartened by the fact the Treasury will put equity up front and take the first loss. Under the program as originally announced, the Treasury put up $20 billion to cover the risks the Fed would face in extending $200 billion in credit. Plosser said the ratio for the expanded TALF would be no different.
He said the Fed would be cautious about the so-called legacy assets it would take on as collateral for loans under the expanded TALF.
“People can disagree, but the argument is that even with the legacy assets, I think the intention is the Fed would still focus on, at least initially, triple-A tranches of these things,” he said. “Some of that has yet to be worked out.”