Federal Reserve Vice Chairman Donald Kohn said on Thursday the U.S. central bank was developing tools to remove its extremely loose monetary policy, but this exit would not happen at all soon.
Any combination of these tools, in addition to the payment of interest on reserves, may prove very valuable when the time comes to tighten the stance of monetary policy, Kohn said in remarks prepared in discussion of a paper presented earlier on Thursday at the Brookings Institution.
As the FOMC has said, that time is not likely to come for an extended period, he said, referring to the policy-setting Federal Open Market Committee (FOMC).
The paper, on the Fed's track record since the failure of Lehman Brothers this time last year, noted the Fed's massive expansion of its balance sheet would not lead to inflation due to its ability to pay interest on reserves that are held with it by commercial banks.
Paying interest on reserve balances also has important benefits and will play a key role in our exit from unusually accommodative policies when the time comes, Kohn said.
Critics say the doubling in the size of the Fed's balance sheet to around $2 trillion since last September will lead to higher prices when growth picks up and banks begin to lend out these excess reserves, fueling another credit bubble.
But the Fed argues that its ability to pay interest on reserves will break this linkage.
Raising the interest paid on those balances should provide substantial leverage over other short-term market interest rates because banks generally should not be willing to lend reserves in the federal funds market at rates below what they could earn simply by holding reserve balances, Kohn said.
This position was supported in the paper by Columbia University economist Ricardo Reis.
Reis also argued that the Fed could target higher inflation in order to lean against the risk that the severe U.S. recession pushes the country into a Japan-style deflation, where falling prices inflicted a decade of stagnation.
Kohn said this might work in the perfect environment of an economic model, but was a bad idea in the real world.
A policy of achieving temporarily higher inflation over the medium term would run the risk of altering inflation expectations beyond the horizon that is desirable. Were that to happen, the costs of bringing expectations back to their current anchored state might be quite high, he said.
The anchoring of inflation expectations has been a hard-won achievement of monetary policy over the past few decades, and we should not take this stability for granted, Kohn added.