Feb. 11 (Bloomberg) -- The Federal Reserve, under political pressure to combat unemployment, risks creating financial instability through its record monetary stimulus, according to University of Chicago Professor Raghuram Rajan.
“A more stable and less aggressive U.S. monetary policy will not only lead to more stable U.S. growth; it will also reduce the volatility of capital flows coming into and out of emerging markets,” Rajan said in a paper scheduled to be published in the March/April issue of Foreign Affairs. He predicted the financial crisis two years before it hit.
The Fed’s Nov. 3 announcement that it would buy $600 billion of bonds through June sparked some of the bitterest political criticism in three decades. Republican lawmakers and officials in China, Germany and Brazil said the so-called quantitative easing may weaken the dollar and ignite inflation.
The decision to embark on another round of quantitative easing was “questionable” because the Fed’s benchmark rate was already near zero and companies were able to borrow at “very low rates,” said Rajan. Consumers were also holding back because “their balance sheets were in disarray,” not because interest rates were too high, he said.
The U.S. central bank is under “enormous” political pressure to be “adventurous with monetary policy” because the unemployment rate is high, yet its policies are unlikely to restore jobs lost as a result of the collapse of the housing market, said Rajan, a former International Monetary Fund chief economist.
“Such pressure can be counterproductive if the Fed’s aggressive policies have little direct effect on employment but instead generate asset price bubbles and risky lending, which eventually impose high costs on the economy, including greater unemployment,” Rajan said.
The unemployment rate fell to 9 percent in January from 9.8 percent in November. Joblessness rose above 9 percent in May 2009, beginning the longest period of unemployment at that level or higher since monthly records began in 1948.
“The Fed’s mandate should be extended to include financial stability explicitly, on par with its current responsibilities to keep inflation low and maximize employment,” Rajan said.
The U.S. also should have a “better social safety net,” such as unemployment benefits, “not only to reassure workers but also to ensure that slow recoveries do not result in frenetic, and ultimately excessive, stimulus spending,” he said.
The Fed’s policies create “very real dangers” around the world because other countries imitate the U.S. central bank by lowering interest rates as they don’t want their currencies to appreciate against the dollar, he said.
“What is appropriate for a U.S. economy that is recovering slowly from a recession may be overly aggressive for emerging markets that are near full employment, creating inflation and asset bubbles in those economies,” Rajan said.
“Over the medium term, if the United States embraces its role as spender too readily, as it seems to have done in the recent past, it risks jeopardizing its creditworthiness -- not even the United States can borrow forever to fund spending,” he said.
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