Feb. 1 (Bloomberg) -- Richmond Federal Reserve Bank President Jeffrey Lacker said the U.S. central bank should avoid favoring specific credit markets such as mortgages and consumer loans and instead boost the money supply with more “neutral” purchases of Treasuries.

The Federal Reserve has increased bank reserves by acquiring $1 trillion in new assets over the past year through credit programs that range from loans to banks to purchases of commercial paper.

“I think we need that monetary stimulus with the severe recession we are in,” Lacker said yesterday in a news conference in Virginia. “But if we are going to expand our balance sheet to that extent, we should try to do it in a way that is neutral in its effects across different credit markets.”

Lacker also said that government injections of capital into banks under the $700 billion Troubled Asset Relief Program may have discouraged private investors from taking stakes. Bank of America Corp., Citigroup Inc. and Goldman Sachs Group Inc. are among the institutions that received capital under the program.

The Richmond Fed president dissented at the Federal Open Market Committee meeting on Jan. 28, preferring to expand the money supply “by purchasing U.S. Treasury securities rather than through targeted credit programs.” The vote highlighted a split between the Board of Governors and some Fed presidents on how to stem the credit crisis and revive economic growth.

Capital Injections

“I do think that the capital injections from the TARP have probably led many market participants to believe that some future injections might also occur,” Lacker said. “I think that that by itself is probably discouraging potential private equity investors.”

The banking system may not return to health until “we get to a point where no further dilutive capital injections from the government are going to take place,” he said.

Lacker’s comments reflect concern that the Fed is gambling with its independence by showing the public it will support specific credit markets. Congressional leaders inquired about the Fed’s ability to loan to troubled U.S. automakers General Motors Corp. and Chrysler LLC when they faced a cash shortage last year.

“If you compare buying Treasuries to a targeted credit program, the targeted credit program will result in probably lower interest rates in the targeted sector, but higher interest rates in the other sectors,” Lacker said.

Fed policy makers left the benchmark lending rate unchanged in a range of zero to 0.25 percent last week and said a global slowdown could push the U.S. economy toward very low rates of inflation that may undercut growth.

Economy Shrinks

A government report later showed the economy shrank at an annual pace of 3.8 percent in the fourth quarter, the most since 1982, as consumer and corporate spending slid. Consumers may cut back further as unemployment rises. Eastman Kodak Co., Target Corp. and Texas Instruments Inc. are among U.S. companies that announced thousands of layoffs last week.

On the economic outlook, Lacker said: “I still expect some positive momentum by the end of the year.”

Fed holdings in the Commercial Paper Funding Facility total $247.5 billion. Next month, the central bank will start the $200 billion Term Asset-Backed Securities Loan Facility, or TALF, to expand credit to households and small businesses.

“I would have preferred a program of buying Treasuries over targeted credit programs like the Term Asset-Backed Securities Lending Facility,” Lacker said. He said he would not be opposed to the purchase of long-term Treasury securities such as 10-year notes and 30-year bonds.

‘Credit Easing’

Lacker’s dissent puts him in opposition to the operating policy of the Board of Governors. Fed Chairman Ben S. Bernanke calls his current policy “credit easing,” meaning the Fed is trying to lower yields in specific credit markets by becoming the temporary financier and investor of last resort.

The debate partly reflects the FOMC’s inexperience in conducting monetary policy when interest rates are at or near zero, said Marvin Goodfriend, a professor at Pittsburgh-based Carnegie Mellon Tepper School of Business and former policy adviser at the Richmond Fed.

“There is broad agreement on monetary policy proper,” he said in an interview. “We haven’t had a longstanding conversation among academics and central bankers to think about credit policies.”

The pushback by Fed presidents also reflects a governance issue. The Fed Board has stepped around the FOMC and invoked emergency powers to set up the large, new credit facilities that have expanded the balance sheet. The Fed’s assets have grown $1 trillion over the past year to $1.9 trillion.

Monetary Base

“I am fine with the size of the monetary base about where it is right now,” Lacker said. With interest rates near zero, the Fed will have to reconsider the size of the base as the economy evolves, he said. The monetary base is the raw stock of money in the economy that includes currency and bank reserves.

He spoke to reporters during a meeting of economists at the University of Richmond’s Jepson School of Leadership Studies. He didn’t have a prepared text.

The Richmond Fed has specialized in monetary policy research for at least three decades, a tradition carried on by former presidents Robert Black and J. Alfred Broaddus Jr., and economists such as Goodfriend, a former adviser to Broaddus. Black called price stability “the only feasible objective” for monetary policy in testimony before Congress in 1990.

“The tradition of the bank is very oriented toward keeping inflation stable rather than tweaking the dials to try and smooth over the business cycle,” says Stephen Stanley, the chief economist at RBS Greenwich Capital Markets who worked at the Richmond bank.

Both Bernanke, 55, and Lacker, 53, have several areas of common ground. Both believe central bank transparency with the public improves monetary policy and favor publishing a numeric inflation target.

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net

Last Updated: February 1, 2009 00:01 EST