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Former Treasury Official who Devised Formula for Rate-Setting Based on Outlook for Inflation and Growth Warns that Inflation Looms, Slams Fed Policy

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Washington’s Blog
Friday, May 15, 2009

Many of us have predicted deflation, followed by massive inflation.

Well, we’re experiencing deflation.

Now, one of the leading experts on interest rates warns that massive inflation looms unless the government starts raising interest rates now.

As quoted by Bloomberg:

The Federal Reserve may soon need to raise interest rates, said John Taylor, the former Treasury official who devised the “Taylor Rule,” a formula for rate- setting based on the outlook for inflation and growth.

“My calculation implies we may not have as much time before the Fed has to remove excess reserves and raise the rate,” Taylor, a Treasury undersecretary under President George W. Bush from 2001 to 2005, said yesterday at an Atlanta Fed conference in Jekyll Island, Georgia…

The Fed helped to trigger the current financial crisis by keeping rates too low for too long, Taylor said.

“Low interest rates led to the acceleration of the housing boom,” he said. “The boom then resulted in the bust, with delinquencies, foreclosures and toxic assets on the balance sheet of financial institutions in the United States and other countries.”…

Taylor said the Fed’s growing balance sheet is a “systemic risk” because it may be difficult to unwind quickly enough without igniting inflation. The Fed’s balance sheet has more than doubled since last September to about $2 trillion as it purchased government and corporate debt to help unfreeze credit markets and support banks’ demand for cash.

Taylor also said proposals for a systemic risk regulator may be misguided. Such a regulator wouldn’t have prevented the financial crisis, he said.

“If it were given its own regulatory powers, they would be very difficult to limit,” he said. “The experience during the panic last fall is not reassuring that such an agency could resolve private institutions without causing more systemic risks than it was trying to reduce.”

A systemic regulator isn’t a “magic bullet” and its existence could affect the performance of other regulators, he said. “I worry about that a lot, the way government works and the way passing the buck tends to happen,” Taylor said.

The Fed and other regulators need to avoid frequent bailouts of companies, he said, adding that policy makers need clear alternatives to avoid multiple rescues.

“Too big to fail occurs way too often,” he said. “We have a bailout mentality. It has gone too far. It has become a presumption” that large financial firms will be rescued.

This article was posted: Friday, May 15, 2009 at 4:05 am

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