Friday, April 23, 2010

Inflation hawks at the Fed

The Economist reports that the FOMC hawks are pressing for the Fed to not only close the TALF (which occurred at the beginning of this month), but also to begin to unwind it by selling $15 to $25 billion per month. In other words, to begin to shrink the Fed's balance sheet and reverse the stance of monetary policy. 

This is despite the fact that bank lending and total private sector credit continue to contract. Contracting credit (deleveraging) is deflationary, which explains why core inflation remains close to zero. Any change in the Fed's stance at this time in the face of continuing credit contraction would be deflationary and would lead to a resumption in the decline in nominal GDP and a continuing decline in government tax receipts (which are declining at the rate of 10% per annum).
So long as the private securitization markets (home mortgages, commercial mortgages, auto loans, credit cards, etc.) remain closed, credit growth will depend entirely on banks, the GSEs and the Fed, and will remain weak. 

To begin to withdraw credit from the market a this time is analogous to encouraging an ICU patient to get more exercise. If and when inflation reappears (which I don't expect), the Fed has ample tools to react: it can shrink its balance sheet and/or raise interest rates. But for now, it should be worried about combating deflation, not inflation.

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