Fed official warns of asset risk

The Federal Reserve would risk its credibility if it bought more assets to stimulate the economy, board member Kevin Warsh said in a speech on Monday.

“I would want to be convinced that the incremental macroeconomic benefits [of buying more assets] outweighed any costs owing to erosion of market functioning, perceptions of monetising indebtedness, crowding-out of private buyers or loss of central bank credibility,” said Mr Warsh.

Until recently the Fed’s focus was on how and when to sell its bond portfolio, but Europe’s fiscal crisis, soft data on the housing and labour markets, and political opposition to further fiscal stimulus have prompted questions about what it could do if the economic situation declined.

In a statement last week, the federal open market committee said “financial conditions have become less supportive of economic growth on balance” and that “underlying inflation has trended lower”.

By in effect creating money to buy bonds, the Fed can flood banks with cash and try to push down long-term interest rates. But some economists doubt that buying more bonds would make much difference. They also fear that long-term rates could actually rise if the Fed lost its credibility as an inflation fighter.

Mr Warsh said asset sales by the Fed “will not take place in the near term”. But he said the Fed should consider gradual asset sales and that they could be kept separate from any decision to raise the Fed funds rate from its current range of 0-0.25 per cent.

That puts Mr Warsh at odds with the Fed’s chairman, Ben Bernanke, and the majority of the FOMC who think that asset sales should only begin after the Fed has raised interest rates for the first time.

Opponents of early asset sales worry about how the markets would react if the Fed started to sell its mortgage-backed bonds. They fear that markets might see it as a signal that higher interest rates are on the way or that it could prompt a premature jump in mortgage rates.

Mr Warsh said that “any sale of assets need not signal that policy rates are soon moving higher”. He said that in recent months the Fed had been able to close many of the special lending facilities it had created during the financial crisis even as rates had been kept low.