The Federal Reserve must be extremely careful when it comes time to wind down its balance sheet, Richmond Federal Reserve Bank President Jeffrey Lacker warned Thursday. Speaking about the dangers of inflation pressures, Lacker stressed the importance of unloading the balance sheet before price stability is threatened.

We have engineered a tremendous expansion in the monetary base over the last six months, and the statement issued by the Federal Open Market Committee last week announced that further rapid expansion lies ahead, Lacker told the Charleston Metro Chamber of Commerce.

But such a large increase in the monetary base cannot be left in place indefinitely without creating quite sizeable inflation pressures, he warned. Choosing the right time to withdraw that stimulus will be a challenge, and I believe it will be very important to avoid the risk of waiting too long.

Lacker's forward looking theme reflected the optimistic tone of his speech, with less focus on the current deep recession and more focus on the positive signs from the housing market.

New single-family housing starts have fallen 80% over three years, and there is little room for further decline, he said. With new construction activity low, population growth will gradually absorb the excess supply of housing that exists in many localities.

In addition, Lacker suggested that consumer lending is picking up, citing data that shows a rebound in auto sales could be around the corner. The 40 plus percent decline in auto sales put the supply well below the rate at which cars and trucks wear out or are totaled in accidents.

Simple replacement demand will put a floor on auto sales going forward, he said.

Lacker, currently a voting member of the Federal Open Market Committee, defended the recent policy actions which included buying up $300 billion in longer term treasury securities.

This is an extraordinary policy response, and I believe it is appropriate, he said.

The FOMC's March decision received support from Lacker, in contrast to his dissent at the January FOMC meeting. At the January meeting Lacker dissented in favor of expanding the monetary base by purchasing U.S. Treasury securities rather than through targeted credit programs. Earlier this month he explained his support for taking that route, and also addressed some of the concerns with purchasing longer-term treasuries.

Safety net support for financial institutions encourages private market participants to view some institutions as 'too big to fail,' and weakens those institutions' incentive to monitor and manage the risks they face in their business strategies and financial market transactions. Lacker said at an event on March 5th.

Intervention to support particular asset classes similarly weakens incentives by encouraging private market participants to discount the cost of credit losses that would depress asset prices, he continued. And this weakening of incentives, by inducing greater risk-taking, eventually increases the ultimate cost of providing safety net protection.

Some have argued that the moral hazard risk has been overshadowed by the need for immediate action due to the credit crisis. Lacker noted and dismissed those arguments, stating that creating a safety net makes large losses more likely to occur.

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