May 22, 2009 / 12:30 AM / 10 years ago

Plosser sees perils in Fed's massive rescue efforts

NEW YORK (Reuters) - The Federal Reserve’s myriad emergency programs for the U.S. economy threaten the central bank’s independence, raising the risk of future inflation, Philadelphia Federal Reserve President Charles Plosser said on Thursday.

To resolve the problem, Plosser argued the Treasury Department should agree to take on riskier assets like mortgage bonds that have been absorbed by the Fed in an effort to free up credit markets.

“When a nation’s treasury or finance ministry and its central bank work too closely together, there is a clear risk that the government’s spending will end up being financed by the central bank’s power to create money,” Plosser said at a Money Marketeers meeting in New York.

“History shows us that you can get very bad economic outcomes with rapidly rising inflation,” he said, citing the case of Zimbabwe as an extreme example.

Plosser, however, said that the U.S. economy is not yet in a position for the Fed to increase its benchmark lending rate, but such a move will eventually have to be made.

“The economy is probably not ready for an increase in Fed funds yet, but at some point we will have to do that,” he said.

Plosser’s comments came on a day that saw widespread selling of dollar assets, including Treasury bonds and U.S. equities, on fears that growing budget deficits could lead to problems down the line.

Though Plosser said the chances of the United States defaulting on its debt seem remote, he shared the anxiety over future problems arising. He argued that conventional economic models that rely on the supposed gap between an economy’s potential and actual output were flawed, potentially understating the danger of inflation.

Pointing to signs that the U.S. recession was becoming less severe, Plosser said the housing sector, which has been in recession for nearly four years, might be reaching a bottom.

But he also warned that any potential recovery would come in fits and starts.

“There are plenty of opportunities for bumps and setbacks along the way,” he said.

BRIGHT LINE

Plosser emphasized the need for autonomous central bank policy to a healthy and stable financial system. He expressed worries about the more than $360 billion in mortgage debt that the Fed has taken onto its balance sheet, part of a commitment to buy up to $1.5 trillion in mortgage and agency debt.

Such obligations, he said, are no less the debt of the U.S. government than an actual Treasury note.

“We need to draw a bright line once again between monetary policy and fiscal policy,” Plosser warned, adding that some aspects of the current debacle were “eerily reminiscent” of the 1970s.

“We have rapid monetary expansion in the face of an apparently substantial output gap.”

In addition to cutting benchmark interest rates to their current zero to 0.25 percent range, the U.S. central bank has taken a string of extraordinary measures to help the country grapple with the worst financial crisis since the Great Depression.

These include a massive boost to liquidity in an effort to prevent a run on large financial institutions, many of which faced a credit crunch that reached fever pitch in September 2008. Bear Stearns and Lehman Brothers were the most prominent casualties of the meltdown, but all large banks and brokerages were affected, and most required a heavy dose of government intervention.

Plosser has supported the Fed’s actions as a temporary support, but has been consistent in warning that there should be a better game plan.

“These actions have the potential of altering the delicate political balance of the (Fed), putting at risk its independence and, in so doing, diminishing its credibility and ability to maintain price stability,” Plosser said.

Editing by Leslie Adler

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