by Calculated Risk on 6/28/2010 12:48:00 PM

From Fed Governor Kevin Warsh: It's Greek to Me

In my view, any judgment to expand the balance sheet further should be subject to strict scrutiny. I would want to be convinced that the incremental macroeconomic benefits outweighed any costs owing to erosion of market functioning, perceptions of monetizing indebtedness, crowding-out of private buyers, or loss of central bank credibility. The Fed's institutional credibility is its most valuable asset, far more consequential to macroeconomic performance than its holdings of long-term Treasury securities or agency securities. That credibility could be meaningfully undermined if we were to take actions that were unlikely to yield clear and significant benefits.

Indeed, the Federal Reserve should continue to give careful consideration to the appropriate size and composition of its existing holdings. Actual sales will not take place in the near term. But, 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. In making this judgment, we should continue to assess investor demand for these assets. Ultimately, in my view, gradual, predictable asset sales by the Fed should facilitate improvements in mortgage finance and financial markets.

Any sale of assets need not signal that policy rates are soon moving higher. Our policy tools can indeed be used independently. I would note that the Fed successfully communicated and demonstrated its ability to exit from most of its extraordinary liquidity facilities over late 2009 and early 2010, even as it continued its policy of extraordinary accommodation.

"Perceptions of monetizing indebtedness"? Although this "perception" is widespread on the internet, it isn't showing up in the bond market.

I definitely agree with Warsh on this point:

"Subprime mortgages were not at the core of the global crisis; they were only indicative of the dramatic mispricing of virtually every asset everywhere in the world."

Tanta said it better a few years ago: "We're all subprime now!"