Fed's Bullard Calls For Lending Exit Plan As Economy Improves

(RTTNews) - St. Louis Federal Reserve President James Bullard called for the development of an exit strategy for the Fed's term lending facilities Tuesday. Warning of the inflation risk in the long term if the Fed's monetary base is left at its current levels, Bullard called for increased focus on an unwinding of the facilities.

"Without an exit strategy, expectations of high inflation may develop," Bullard said in prepared remarks in a speech at a Global Interdependence Center event held at the Federal Reserve Bank of Philadelphia. "If expectations of inflation feed into today's long-term yields, those yields will rise today and hamper recovery prospects."

If such a strategy is implemented, Bullard said, then inflation expectations will be kept in check.

There are three issues that need to be accounted for when planning the exit, Bullard said. They include assessing the fading need for liquidity facilities, eliminating the ongoing asset purchase program, and planning an exit from zero short-term nominal interest rates.

Many Fed officials predict that as credit markets recover, the need for emergency lending facilities will decrease naturally.

While still stressed, markets have improved, Bullard said.

"By many metrics, financial markets are less strained than they have been," Bullard said. "Many of the programs are being used less intensively than in the recent past."

"As market functioning improves, these programs are not as necessary," he added, "Liquidity programs also cause the monetary base to rise rapidly, but are easier to unwind."

These programs can unravel "naturally," Bullard said, but they will likely be in place until 2010.

Purchasing treasury securities - up to $300 billion by autumn - was one of the most significant steps taken by the Fed to calm markets. However, even as liquidity facilities unwind, the purchases mean that the Fed's monetary base will still remain at twice its size in September 2009 than it was in September 2008.

"The monetary base is expanding rapidly. This is unprecedented in U.S. postwar monetary policy," said Bullard. "This is one way to move inflation higher in an environment where inflation is 'too low' and short-term nominal interest rates are near zero."

He added, "In teaching money and banking, we say, 'permanently doubling the money supply eventually doubles the price level.'" While this may take some time, Bullard said, "probably 'more later than sooner,' this gives a rough idea of the type of threat we face."

He suggested selling assets from the Fed's SOMA (System Open Market Account) portfolio to finance purchases; using the Treasury's supplementary financing account and instituting the issuance of "Fed bills" in order to reduce the size of the monetary base.

In the future, Bullard suggested working on a framework to guide the purchase of assets in the current crisis and potential future crises.

"I would like to see a policy feedback rule that could describe, in rough terms, what level of asset purchases is appropriate in the current environment," he stated. "While we are not there yet, I want to encourage staff to work in this direction. Without this, we have been forced to make judgment calls."

Finally, Bullard addressed the issue of raising interest rates. While the FOMC continues to pledge that it will keep interest rates exceptionally low for some time, eventually economic activity will improve and it will be necessary to raise rates from their current target range between 0 and 0.25 percent.

"Should economic performance improve and inflation begin to rise…the promise is to maintain zero rates longer than might be indicated by simple rules of thumb," Bullard said. "It also means that most of the action on monetary policy will be with the asset purchase program in the near term."

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