The Federal Reserve has not been clear enough about how it intends to unwind its unprecedented monetary easing campaign, and some of the tools it expects to use may not work, monetary experts will tell Congress on Thursday.
John Taylor, a Stanford University economist and author of a key central banking rule of thumb, will testify before the House of Representatives Financial Services Committee that the Fed's unorthodox approach has not only threatened its independence but also made policy making more difficult.
By taking these extraordinary measures, the Fed has risked losing its independence over monetary policy, said Taylor, arguing that such steps veered too far into the arena of fiscal policy.
Unwinding them involves considerable risks, said Taylor, who was a Treasury official during the Bush administration, in prepared testimony made available on the House committee's website on Wednesday.
The Fed has taken pains to assure investors and the public that it can and will pull back on its zero percent interest rate policy when the times comes, probably through a mixture of draining credit from the banking system, raising the interest it pays on bank reserves, and selling some of its assets.
But this approach has serious shortcomings, Martin Goodfriend, a professor of economics at Carnegie Mellon University, will testify.
For one thing, the reverse repurchase agreements through which the Fed plans to drain funds from the system would make its policy success too dependent on the whims of the private sector, Goodfriend said in his prepared testimony.
Large-scale reverses would expose Fed to substantial counterparty risk, said Goodfriend, who is also a research associate at the National Bureau of Economic Research, which is the arbiter of when U.S. recessions begin and end. This would complicate the Fed's management of financial markets, especially in times of turmoil.
He added that the Fed's authority to pay interest on bank reserves, granted by Congress after the crisis started, will not prevent borrowing costs from drifting undesirably lower during a tightening unless some technical problems relating to mortgage finance agencies Fannie Mae and Freddie Mac are overcome.
Testimony by Goodfriend and Taylor, along with that of former Fed Governor Larry Meyer and Johns Hopkins University economics professor Laurence Ball, will follow testimony by Fed Chairman Ben Bernanke.
Bernanke's testimony is entitled Unwinding Emergency Federal Reserve Liquidity Programs and Implications for Economic Recovery.
In order to provide more specific guidance on how it intends to pull back, the Fed needs more than just an exit strategy, said Taylor.
One reasonable exit rule would reduce reserve balances by $100 billion for each 25 basis point increase in the federal funds rate, Taylor said in his testimony.
Johns Hopkins' Ball says he is less concerned about the Fed's ability to remove stimulus than about the possibility that it will be urged to do so while the economy is still fragile.
The Fed should give greater weight than usual to unemployment. In particular, it should not raise interest rates until we see major progress in reducing the unemployment rate, said Ball.
U.S. unemployment, currently at 9.7 percent, remains near its highest levels since the 1980s. Over 8 million Americans have lost their jobs in the last two years. Many economists believe the downtrodden market will keep inflation at bay, making the Fed's job of maintaining price stability easier. Others, however, see the spike in bank reserves as presaging a surge in inflation down the road.