Fed's Hoenig warns against moon creatures and inflation

The 2010 Outlook and the Path Back to Stability, by Thomas M. Hoenig, President, Federal Reserve Bank of Kansas City: ...Policy Challenges Ahead As I have indicated, a key contributor to the economic recovery is the extraordinary fiscal and monetary stimulus provided by governments and central banks around the world. In the U.S., we have seen the largest fiscal stimulus in history...

While these policy actions have been instrumental in helping to stabilize the economy and financial system, they must be unwound in a deliberate fashion as conditions improve. Otherwise, we risk undermining the very economic performance we hope to achieve. In the case of fiscal policy, the ballooning federal deficit must be controlled and reduced. ...

As the private sector recovers, increasing demand to finance both public and private debt will likely place upward pressure on interest rates. Eventually, there will be pressure put on the Federal Reserve to keep interest rates artificially low as a means of providing the financing. The dire consequences of such action are well documented in history: In its worst cases, it is a recipe for hyperinflation.

Addressing the deficit will be made all the more complicated by the fact that many of the stimulus programs are scheduled to wind down in 2011 at the very time the Bush administration tax cuts are also scheduled to expire. It will be an extremely abrupt shift in fiscal policy from stimulus to restraint that will cause the economy to weaken. Addressing the deficit under these types of circumstances will be controversial and desperately unpopular. ...

In the case of monetary policy, the challenges are no less daunting. The Federal Reserve must curtail its emergency credit and financial market support programs, raise the federal funds rate target from zero back to a more normal level, probably between 3.5 and 4.5 percent, and restore its balance sheet to pre-crisis size and configuration. ... However, normalizing monetary policy and the Federal Reserve’s balance sheet will be a ... contentious undertaking, and there are differing views regarding when this process should begin, how fast it should proceed, and what form it should take.

One view is that the Federal Reserve should delay interest rate normalization until there is more certainty that the economy and financial markets have completely recovered from this crisis. At that time, the accommodation can begin to be removed. Those who hold this view believe that high unemployment and low inflationary pressures due to excess capacity create considerable economic downside risks if the Federal Reserve removes stimulus. Their biggest fear is of the “double-dip” recession. In their minds, these immediate risks continue to outweigh concerns about long-term economic performance.

This is an appealing argument. The recovery is in its early stage, and weak data continue to emerge in some reports. State and local governments remain under severe fiscal pressures despite considerable federal assistance. Business investment spending for nonresidential construction and equipment remains weak. Additionally, those parts of the country heavily exposed to the subprime lending bust and to the auto industry remain depressed. Also, there is no denying the fact that despite improvements, labor markets and parts of our financial system remain under stress. Thus, while the economic and financial recovery is gaining traction, risks and uncertainty remain major deterrents to removing the stimulus.

Unfortunately, mixed data are a part of all recoveries. And, while there is considerable uncertainty about the outlook, the balance of evidence suggests that the recovery is gaining momentum. In these circumstances, I believe the process of returning policy to a more balanced weighing of short-run and longer-run economic and financial goals should occur sooner rather than later. ...

As I have already said today, experience has shown that, despite good intentions, maintaining excessively low interest rates for a lengthy period runs the risk of creating new kinds of asset misallocations, more volatile and higher long-run inflation, and more unemployment — not today, perhaps, but in the medium- and longer-run. ...

Low rates also interfere with the economy’s ability to allocate resources and distort longer-term saving and investment decisions. Artificially low rates discourage saving and subsidize borrowers at the expense of savers. Over the past decade, we channeled too many resources into residential construction and financial activities. During this period, real interest rates—nominal rates adjusted for inflation—remained at negative levels for approximately 40 percent of the time. The last time this occurred was during the 1970s, preceding a time of turbulence. Low interest rates contributed to excesses. It would be a serious mistake to attempt to grow our way out of the current crisis by sowing the seeds for the next crisis. ...