Fed’s Kohn, Dudley Defend Size, Scope of Emergency Loan Plans

Two of the Federal Reserve’s top policy makers defended the Fed’s emergency lending, saying the programs won’t cause an inflationary surge or create “significant” risk for taxpayers.

Vice Chairman Donald Kohn, speaking yesterday in Nashville, Tennessee, said the Fed has loaned to “sound” borrowers and plans to disclose more about such credit. New York Fed Bank President William Dudley, speaking at the same conference, said he’s “not worried at all that” a doubling in the central bank’s balance sheet to $2.19 trillion will spur inflation.

Policy makers are pursing an unprecedented strategy to revive the economy by providing credit to companies other than banks and cutting the main interest rate to as low as zero. The Fed plans to buy as much as $1.25 trillion in agency mortgage- backed securities this year and is providing financing for securities backed by loans to consumers and small businesses.

The increased credit has provoked concerns prices will surge. Central bank officials are “dramatically underplaying the risks and liability side of the balance sheet,” former St. Louis Fed President William Poole said in an interview at the conference.

“We are very vulnerable to an inflation explosion,” said Poole, a senior economic adviser to Merk Investments LLC in Palo Alto, California.

Former Fed Chairman Paul Volcker said Congress will probably review the authority granted to the Fed following the expansion in its assets.

Political Reaction

“I don’t think the political system will tolerate the degree of activity that the Federal Reserve, in conjunction with the Treasury, has taken,” Volcker, head of President Barack Obama’s Economic Recovery Advisory Board, said in remarks to the conference at Vanderbilt University.

U.S. lawmakers from both political parties, including House Financial Services Committee Chairman Barney Frank, have expressed concern in recent months that the central bank has overstepped its authority by providing emergency credit.

“I think for better or for worse we are at a point where the Federal Reserve Act, after all that has been happening in the last year or more, is going to be reviewed,” Volcker said.

Central bank officials are “underestimating the political forces they’re going to face once the recovery starts,” said Poole, a contributor to Bloomberg News.

Fed Vice Chairman Kohn said in his speech “intense scrutiny” of the central bank’s emergency programs is “natural and appropriate.”

No ‘Fundamental Change’

Still, such attention “should not lead to a fundamental change in our place within our democracy,” he said. “And I believe it will not.”

While the central bank may be channeling credit to some markets more than others, “we are not taking significant credit risk that might end up being absorbed by the taxpayer,” Kohn said. “For almost all the loans made by the Federal Reserve, we look first to sound borrowers for repayment and then to underlying collateral.”

Kohn made an exception for financial institutions such as Bear Stearns Cos. and insurer American International Group Inc. that would cause widespread disruption in markets should they fail. Such companies would “probably have higher credit risk,” he said.

Kohn said the Fed would disclose more details on its loans and borrowers involved in central bank programs “in coming weeks.” The Fed’s refusal to provide such information prompted a lawsuit by Bloomberg News in November and criticism from U.S. Republican Senator Richard Shelby of Alabama and other lawmakers.

Public Interest

“Understandably, given the sharp increase in loans to new institutions and markets, the public is naturally interested in our lending practices,” the vice chairman said.

Dudley said he sees no legitimate reason for rising “investor anxiety” that participation in the $1 trillion Term Asset-Backed Securities Loan Facility will provoke government scrutiny.

The TALF, aimed at supporting financing of loans to credit card borrowers, students, car buyers and small businesses, is off to a “slow start,” Dudley said, recording just $6.4 billion in loans.

Investors have shied from joining some emergency credit programs after lawmakers criticized the compensation practices of financial companies that accepted taxpayer funds to shore up capital, Dudley said.

Misplaced Fears

“My own view is that these fears are misplaced,” Dudley said. He said TALF is “completely a Federal Reserve program and operation,” and that government funds would only be used to protect the Fed against a credit risk such as a default.

Treasuries fell for a fourth week as better-than-expected earnings at banks including Goldman Sachs Group Inc. and JP Morgan Chase & Co. bolstered speculation the longest recession in the postwar era may be easing. The yield on the 10-year note rose two basis points this week, or 0.02 percentage point, to 2.95 percent.

In an unusual public exchange between a current and former U.S. central banker, Volcker asked Kohn to explain the merits of a 2 percent inflation goal, instead of a 1 percent or 3 percent objective.

“By aiming at 2, you have a little more room on nominal interest rates, a little more room to react to an adverse shock to the economy or better odds of stabilizing the economy,” Kohn said.

Clearer Objective

“By being clearer about our objective about what we consider price stability, we will have armed ourselves to lean against tendencies for inflation to rise,” Kohn said.

The vice chairman also said that he doesn’t expect deflation, or a consistent decline in consumer prices, over the next five years, while not ruling out the possibility.

The Fed’s credit programs “have helped ease financial conditions, though they can’t address all the problems in financial markets,” Kohn said. “The situation in financial markets and the economy would have been far worse if the Federal Reserve hadn’t taken the actions.”