Getting The Fed Out of its Box, Mishkin

Writing for the Tuesday’s WSJ, former member of the Board of Governors of the Fed Frederic Mishkin says a commitment by the Federal Reserve to fiscal discipline could enable expansionary monetary policy. Here are few excerpts from Mr. Mishkin’s article:

From theWSJ: Although an expansion of Treasury bond purchases by the Fed would have the benefit of lowering long-term interest rates temporarily to stimulate the economy, in the current environment it could be dangerous for two reasons. First, it might suggest that the Fed is willing to monetize Treasury debt. The Fed does not, and should not, want to make it easy for the Treasury to sell its debt and thereby be an enabler of fiscal irresponsibility. Second, if the Fed loses its credibility to resist pressures to monetize the debt it could cause inflation expectations to shift upward, thereby leading to a serious problem down the road.

The Fed is boxed in. The slack in the economy that is likely to persist for a very long time suggests the need for stimulative monetary policy to lower long-term interest rates through the purchase of Treasurys. The fiscal situation argues against this policy action, because it would weaken the Fed’s inflation-fighting credibility.

How can the Fed get out of the box and pursue the expansionary monetary policy that is needed right now? The answer is that the Obama administration and Congress have to get serious about long-run fiscal sustainability. Large budget deficits naturally occur during severe recessions when tax revenue undergoes a substantial decline. In addition, fiscal stimulus to promote economic recovery when the economy is in a severe recession is a sensible prescription.

We shouldn’t lose track of fact that excess reserves in the banking system are currently at mid $800 billion level, up from $2 billion in August of last year.

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