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By Ronald Fink
New York Federal Reserve President William Dudley expressed
confidence on Monday that the radical expansion of the central bank’s balance
sheet stemming from its efforts to counter the financial crisis would not
hamper its ability to control inflation.
Critics have expressed concern that the rapid growth of the
Fed’s balance sheet, which has resulted from its purchase of financial assets
other than Treasury securities in order to inject liquidity into credit markets
and troubled banks, will ultimately lead to an inflation problem. The central bank now has a huge amount
of so-called “excess” reserves from banks within its system resulting from
those asset purchases.
In a speech at a conference at Columbia University, Dudley acknowledged
the anxiety stems from the fact that periods of rapid growth of the monetary
base—currency plus bank reserves—in the past have typically been followed by
rapid credit growth and inflation.
But the former chief economist of Goldman Sachs said he did
not believe fears over the Fed’s balance sheet are “well-founded.” He cited the
central bank’s new authority, which Congress granted last year, to pay interest
on such reserves. Calling it “a new tool,” Dudley said it “should enable us to
cut the link between the size of our balance sheet and credit creation and
inflation.”
He explained that the Fed can incentivize banks to hold excess
reserves rather than lend them out simply by raising the interest rate it pays on
such reserves.
“That should work,” Dudley said, “because the price of
credit is an important determinant of credit demand.”
He conceded the Fed’s exit from its current monetary policy
stance would be more complicated than normal. “Normally, when we exit, we
simply decide when we are going to raise the federal funds rate target,” the
New York Fed chief said. “This time, we have a broader set of decisions to
make. For example, do we drain reserves from the banking system? Is it better
for the banking system to operate with $500 billion of excess reserves or $1
trillion? This is an issue we have to explore further.”
But he said the Fed is testing is ability to drain reserves
through the use of reverse repurchase agreements. And he insisted that he
believed the process would be manageable.
“The fact we have more levers doesn’t mean that we will have
trouble exiting when the time comes,” Dudley added. “It just means that we will
have more choices to make.”
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