Fed policy challenged

07/10/2010 | Sid Verma and Taimur Ahmad

Leading economists are sounding the alarm over the global fallout of monetary policy in the west, amid fears that ultra-loose policies are once again fuelling excessive risk taking

 John Taylor
Taylor: urging caution
Leading economists are sounding the alarm over the global fallout of monetary policy in the west, amid fears that ultra-loose policies in the US and Europe are fuelling excessive risk taking and a repeat of the practices that led to the financial crisis.

Stanford economist John Taylor has warned that central bank policy was encouraging the same “search for yield and excessive risk taking” that contributed to the global financial crisis.

He also cautioned against the adoption of unconventional monetary policies – as the US Federal Reserve mulls a resumption of quantitative easing, including purchases of government bonds, in a bid to shore up a flagging US economy.

“It [further quantitative easing] wouldn’t be a good idea. [The Fed] has such a huge balance sheet as it is,” Taylor, author of the Taylor Rule on interest rate policy, told Emerging Markets.

William White, former chief economist at the Bank for International Settlements (BIS), said monetary policy in advanced economies is creating financial imbalances and headwinds that “now threaten sustainable growth” and focus “solely on the shorter term effects on domestic demand.”

The Fed has pumped $2 trillion into the economy since September 2008 through quantitative easing. Fears of a double-dip recession or a deflationary spiral that could lead to a prolonged loss in economic output have galvanized Western central banks to unleash yet-more liquidity.

Senior Fed officials have signalled more asset purchases could be announced at a policy meeting in the first week of November. The UK government bond market has rallied this week on hopes the Bank of England will announce a new round of quantitative easing today.

Phil Suttle, chief economist at the Institute of International Finance, said central banks in the West are prisoner of financial markets, fearing unexpected policy action will ignite market turmoil.

Randall Kroszner, a former board member of the Federal Reserve, said the US central bank should purchase long-term US government bonds. “The fear of disinflation – that will lower consumption, increase the nominal value of debt, decrease wages, increase foreclosures and places pressures on banks – will galvanize them to action,” he said.

While the Fed’s near-zero interest rate policy is broadly appropriate, further credit easing dangerously increases banks’ dependency on the central bank, said Taylor. Meanwhile, acquisition of public and private debt is compromising the independence of monetary policy, and could fuel inflation.

“I would not increase interests rates now in US, Europe and Japan – that would be very damaging for the economic recovery,” said Jose Vinals, director of the monetary and capital markets department at the IMF.

Although Vinals said further credit easing will have marginal returns as interest rates are already low, “Central banks should be ready to rescale quantitative or credit easing if the situation requires but bearing in mind that the room for maneuver is now more limited.”

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