In a speech last week, San Francisco Fed President Janet
Yellen outlines an escape plan for the Fed's current
dilemma.
There are two direct threats to the Fed's current policies. One is that the Fed's radical increase in the monetary base will create inflation (see
Flirting with Inflation and
Laffer: Inflation Ahead ). This massive expansion in the base has largely been provided to the big banks, but the funds are still on deposit at the Fed, earning interest. The banks have not yet begun to move this money into the economy on a large scale.
The Fed's plan is to keep this money on deposit at the Fed by raising the interest rate paid on bank reserves. But this may raise interest rates throughout the economy.
An increase in the interest rate on reserves will induce banks to lend money to us rather than to other banks and borrowers, thereby pushing up the federal funds rate and other rates charged to private borrowers throughout the economy. The ability to pay interest on reserves is an important tool because, as I mentioned, it’s conceivable that, even if the economy rebounds nicely, the credit crunch might not be fully behind us and some financial markets might still need Fed support. This tool will enable us to tighten credit conditions even though our balance sheet wouldn’t shrink.1
The second threat is that government
overspending will cause higher interest rates on government bonds (see
Treasury Yields Headed Higher).
Yellen doesn't directly address this issue. Instead, she argues that government deficits don't cause
inflation, noting the example of Japan. But she does cite one historical example when deficits did lead to higher interest rates.
Consider the case of the large deficits in the United States in the 1980s. We did not see a run-up in inflation then. On the contrary, the deficits soared just as inflation was coming down. Those deficits did, however, contribute to higher interest rates, which made education and investment more expensive. 1
Whether they cause inflation, it seems either of these scenarios is likely to cause higher interest rates.
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At the time of publication Mr. Cale held long positions in TBT.
Source:
1. Janet Yellen. A View of the Economic Crisis and the Federal Reserve’s Response.
Speech to the Commonwealth Club of California
San Francisco, CA. June 30, 2009.
http://www.frbsf.org/news/speeches/2009/0630.html
© 2009 Michael Cale
