Warsh Urges `Strict Scrutiny' of Any Decision to Expand Fed Balance Sheet

Federal Reserve Governor Kevin Warsh said any decision by the central bank to expand its $2.35 trillion balance sheet must be subject to “strict scrutiny.”

Warsh, in a speech in Atlanta, said he would need to be convinced that the economic benefits of such a move “outweighed any costs owing to erosion of market functioning, perceptions of monetizing indebtedness, crowding-out of private buyers, or loss of central bank credibility.”

Fed policy makers last week signaled Europe’s debt crisis may harm the U.S. economy, saying “financial conditions have become less supportive” of growth and repeated a pledge to keep interest rates near zero “for an extended period.” At the same time, officials are laying plans for an eventual exit from record monetary stimulus to head off an outbreak of inflation.

Analysts including Avery Shenfeld, chief economist with CIBC World Market in Toronto, and former Richmond Fed President J. Alfred Broaddus have said weakness in the economy increases the chances the Fed would resume expanding its balance sheet. The Fed bought $1.6 trillion in housing debt and Treasury securities since late 2008 as it battled the financial crisis.

“Some believe the Federal Reserve should do more, including expansion of its balance sheet,” Warsh said. “In my view, any judgment to expand the balance sheet further should be subject to strict scrutiny.”

Warsh, echoing some of the language of the Federal Open Market Committee’s statement, said the recovery is “proceeding” and the “labor market is improving, albeit gradually.” He added that “employers appear quite reluctant to add to payrolls,” and that most broad inflation measures “remain subdued.”

Yields Fall

Yields on U.S. Treasury notes have fallen as investors concerned about the danger of default by Greece and other European governments sought the safety of U.S. government debt.

The yield on the 10-year note decreased seven basis points, or 0.07 percentage point, to 3.04 percent at 1:29 p.m. in New York after touching 3.03 percent, the lowest level since April 29, 2009.

“If volatility in financial markets persists at elevated levels, the expected pickup in business capital expenditures may disappoint,” Warsh said. Should volatility abate, he said, “the economic recovery should continue apace.”

During an audience question period, Warsh said his forecast for growth in the second half of the year isn’t “markedly different” than it was two months ago. He added that a recovery of the U.S. housing market depends more on the outlook for jobs than on interest rates.

Strength of Housing

“The most important determination of the strength of the housing market is employment,” he said.

Policy makers won’t raise interest rates until the first quarter next year, based on the median estimate in a Bloomberg News survey of economists this month. The European crisis has prompted analysts at Barclays Capital Inc., Credit Suisse, UB AG and Deutsche Bank AG to push back by several months their predictions for a Fed rate increase.

Fed officials are still preparing for an eventual tightening of credit. The central bank this month held its first test auction of term deposits, a tool to help drain hundreds of billions of dollars from the banking system. At the April meeting, policy makers debated when and how fast to sell $1.1 trillion of mortgage-backed securities that were purchased to lower home-loan rates and boost the economy.

“Depending on the evolution of the economy and financial markets, we should consider a gradual, prospective exit -- communicated well in advance -- from our portfolio of mortgage- backed securities,” Warsh said today. “Actual asset sales will not take place in the near term,” he said.

Warsh said the federal funds rate should remain the “dominant tool in the conduct of operations going forward” because it’s the most “clearly understood” and “effective.”

To contact the reporter on this story: Steve Matthews in Atlanta at smatthews@bloomberg.net

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