Excess bank reserves: dry tinder for inflation, or a tool allowing for a controlled burn?

William Dudley, president of the Federal Reserve Bank of New York, argued the latter.

In a speech at New York University's Stern School of Business on Monday, Dudley tried to appease critics who fear that accommodative monetary policy is courting inflation — and critics who fear that if inflation does take off, the central bank will not have the ability or the will to fight it.

Dudley argued that there is enough slack in the economy and enough protection against the effect of rising commodities prices to ward off dangerous levels of inflation. But just in case, the Fed can raise the interest rate paid on excess reserves to restrain the flow of credit into the economy. Moreover, he said, the Fed has no self-interest in keeping short-term rates low, because it does not have to answer to anyone if a rate uptick squeezes the net interest margin on the central bank's securities portfolio.

"The Federal Reserve's net income statement does not drive or constrain our policy actions," Dudley said. "In short, we act as a central bank; we are not an investment manager."

In other words, Dudley sees the Fed as having both the ability and the will to tighten monetary policy if it needs to. But it's an untested theory.

"In this regard, the proof of the pudding will be in our actions," Dudley said. "Talk is cheap. What is key is that the appropriate policy steps are taken in a timely manner."

Pushing off the day of reckoning is a U.S. economy that, for all its improvements since the depths of the financial crisis, has yet to cultivate strong payroll employment gains. "Even if we were to generate growth of 300,000 jobs per month" — more than triple the gains in each of the past three months — "we would still likely have considerable slack in the labor market at the end of 2012," Dudley said.

The bleak jobs data, in addition to below-average utilization rates for industrial capacity, suggests there is room for the Fed to keep rates low. "Nevertheless, there are several reasons why we need to be careful about inflation even in an environment of ample spare capacity," Dudley said. He listed three but poked holes in two of them, and challenged the Fed to keep the third from materializing.

Yes, he acknowledged, commodity prices generally have risen over the past decade. But recent pressures on food prices, much of which came from a drop in production due to bad weather, should reverse themselves as more typical weather returns. Meanwhile, commodities account for "a relatively small share of the [U.S.] consumption basket." All that, he argued, should help take care of another big concern of inflation hawks: that the pressure on commodities prices will pass through to core measures of inflation.

That leaves an unmooring of inflation expectations as the biggest risk to higher underlying inflation over the next year or two, Dudley said. As a result, the Fed must "communicate effectively about its objectives, the efficacy of the tools that it has at its disposal to achieve those objectives, and the willingness to use these tools as necessary," Dudley said, adding that if inflation expectations "were to become unanchored because the Federal Reserve failed to communicate clearly, this would be a self-inflicted wound that would make our pursuit of the dual mandate of full employment and price stability more difficult."

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.