Financial life support: federal reserve bank execs take on monetary policy.

AuthorKinder, Peri

In June, the Federal Open Market Committee (FOMC), chaired by Ben Bernanke, voted to continue the purchase of mortgage-backed securities to the tune of' $40 billion per month, as well as longer-term Treasury securities at $45 billion each month. With moderate improvement in the economy, the FOMC hopes this action will support mortgage markets and improve financial conditions.

Bernanke stated he would like to see these monthly purchases fade out slowly, perhaps stopping the acquisitions completely by mid-2014. Will the hope that unemployment rates will be below 7 percent at that time, FOMC's asset purchases will exceed $1 trillion.

FOMC member James Bullard, president and CEO of the Federal Reserve Bank of St. Louis, voted against the measure announced in June, due to fears about low inflation. On the other hand, Charles Plosser, president and CEO of the Federal Reserve Bank of Philadelphia, would like to see the timetable for tapering significantly accelerated.

A Prudent Approach

The low inflation rate is a big worry to Bullard. With inflation running below its 2 percent objective, he asks, "Why has inflation been so low? We do not have a good explanation, so we should be careful."

He suggests a theory that over the last year, global commodity prices have been soft, possibly because of the recession in Europe and slower-than-expected growth in China.

Bullard also notes that recent FOMC policy announcements have been followed by a substantial rise in Treasury yields. He suggests three possible reasons for this increase: Substantial improvement in the economy, increased inflation expectations and an optimistic outlook for the U.S. economy.

If macroeconomic performance was stronger than expected, Bullard says bond yields would naturally rise. This could explain the increase, but he says the evidence to validate that theory is mixed. "By some measures, labor markets have improved since last September. ... But other measures suggest otherwise. Real growth in gross domestic product, for instance, has been slow."

It is also possible that bond yields increased in reaction to higher-than-expected inflation, and could be a traditional reason to tighten monetary policy. However, inflation is still very low, and the immediate reaction to the FOMC announcement was to send inflation 'expectations even lower.

"Accordingly, the increase in bond yields is not associated with an increase in inflation expectations," he says.

As for optimism in the U.S...

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